Why are VCs Pulling Term Sheets?

This started out as a slightly snarky and irritable response to a @VCStarterKit tweet (sorry). On reflection, I thought it might be worth putting together a proper (albeit quick and dirty) post on why VCs are pulling term sheets and slowing down investment processes. There are many issues and I’ll try to categorise and summarise them as best I can. No doubt entrepreneurs AND VC Twitter will flay me alive but no good deed goes unpunished…

So, I’m going to start with the BAD…there are, of course, VCs who see #coronavirus as an opportunity to reset terms in their favour. I think they are very much in the minority and, in their defence, your company may not be worth what it was 10 days ago, which brings me to the second point.

MARKETS. The #Coronavirus crisis is dramatically changing perceptions of many market opportunities. Some are becoming much more attractive, most are becoming less attractive, in the short term at least. The problem is it’s not always clear which is which, especially as second order effects start to emerge. VCs will, naturally, want to think that through before pulling the trigger and they know they probably have the time to do so as deals become less competitive.

They are also conscious that, as revenues decline and potentially remain depressed for a prolonged period, their assessment of overall capital requirement in companies (existing portfolio and new investments) may need to be adjusted materially.

Beyond that, there are several crucial systemic issues to consider and that’s what I want to concentrate on because it’s less obvious. Investors in VC funds (Limited Partners or “LPs”) don’t generally deliver their entire investment commitment up-front. Instead, they sign binding legal commitments to provide the funds on an “as needed” basis. In other words, when a VC makes an investment, they pony up their share against a “drawdown” notice.

That’s fine in the normal run of things and, if an LP reneges on their commitment, all sorts of punishments are visited upon them. However, in circumstances where multiple LPs in a fund simultaneously find themselves unable to meet drawdowns, pressure will quickly come on VCs to limit drawdowns and slow down their investment pace.

A VC has little choice but to comply. Very few VCs are in a position to tell multiple LPs “pay up, or else”.

Most significant LPs will have a portfolio of commitments to multiple VC and PE funds across multiple vintages. They rely, in part at least, on liquidity (i.e. exits) from mature funds to fund their commitments to newer funds. That stream of liquidity is likely drying up quickly just now and they really do not want to have to sell other assets (stocks, etc.) to fund drawdowns in the current climate. So, the whole system slows down.

Beyond that there are second order impacts. Large LPs typically operate reasonably strict asset allocation models. They might allocate 60% to publicly traded equities, 25% to government bonds, etc. and, maybe, 5% or less to “alternatives” such as VC and PE funds. If the value of your other assets crashes (as it just has), your VC/PE commitments suddenly expand as a percentage of the overall portfolio. In order to bring the portfolio back into balance, LPs often stop making commitments to new VC or PE funds. That makes it much harder for VCs to raise new funds.

For existing VC funds, this (together with the system slow down described above) probably means that it is probably going to be much harder to raise additional capital for existing portfolio companies. So, they start to reassess their own allocations for follow-on in their existing portfolio. That might also mean fewer new investments in the fund.

How do we get out of this vicious cycle? It’s simple. The brave investors who keep on investing (albeit at a slower pace) end up investing in some great companies at attractive valuations. As the world returns to normal and those businesses scale rapidly, VC returns improve greatly, and the asset class starts to look very attractive again. Simultaneously, other asset classes are bouncing back, delivering liquidity and bringing LP portfolios back into balance giving them firepower for new commitments.

I’ll finish with the caveats:

· US, European and Asian VC markets are different because the LP bases are different.

· Some VCs have more power over their LPs than others (who gips Sequoia?).

· Some VCs have different funding models, especially corporate VCs and publicly quoted firms who invest from their balance sheets.

· Your mileage may vary, etc.

And the most important one of all…this is a personal opinion, not the view of (any of) my employers, partners, colleagues, friends, etc., etc. …and it’s gone midnight so it ain’t pretty…

Venture Partner at Draper Esprit. Previously founder at Exceptis & Similarity Systems and partner at Trinity Venture Capital. Recovering angel investor.

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