Rob Day | December 2, 2008 at 6:21 AM

Is flat really the new up?  Not for B rounds.

Jeff Bussgang (of Flybridge, and focused on internet investments) wrote a very interesting column over at PE Hub yesterday (sub req’d), where he made a few arguments about the overall VC environment right now that are worth noting:

1.  Valuations are dropping to the point where “it will be a privilege to close a flat round with an outsider.”

2.  The impact is felt hardest on Series B and Series C rounds because “almost no one is paying up for pre-revenue companies never mind fast growth revenue companies.”  (Not sure what “never mind” means in this context)

3.  All this is because exit assumptions are being pushed back by 2-3 years, and therefore investors will need to plan on startups requiring significantly more capital to get to that exit.

4.  Because of the additional reserves thus necessary to keep in hand, VC new deal activity is likely to dry up a bit as they target fewer deals with their remaining cash available.

This is all very well articulated and generally smart, and may be holding true for VC overall, but I don’t believe it’s entirely accurate for the cleantech sector in particular.  Let’s take the points in turn:

1.  Valuations are dropping, but anecdotally at least I’m not seeing a lot of cram-downs, at least not yet.  Now, there are definitely some exceptions, and I think we certainly will see some high-profile down rounds, downward valuation pressure, and some smoking craters.  But it’s unclear in which stages they’ll be most felt.  If you look back at what I wrote a couple of months ago, my feeling is that the really high-flying, high cashburn businesses will be hardest hit, as the “pre-revenue mezz rounds” are the ones most likely to be affected by exits being so slow.  So far I think I’ve been mostly right (for once!), which brings us to point #2:

2.  Bussgang posits that Series B and Series C will be the hardest hit.  What he really means to say is that Series A valuations aren’t seeing as much downward pressure, I don’t believe he meant to be so specific about stage, he was just drawing a distinction between Series A and follow-on rounds.  But I think he missed the mark a bit, because Series B rounds appear to still be going strong.

I did a very informal and probably inaccurate tally of the rounds mentioned on this site for Oct/Nov versus those for Aug/Sept.  If Bussgang’s take is accurate in the cleantech sector, we should be seeing a drop-off in deal numbers for both Series B and Series C, with Series A remaining strong.

Well, 2 for 3.

_________Seed+A____SerB_____SerC+__

Aug/Sept          23               17                17

Oct/Nov           29               14                 8

It’s a small and unscientific dataset that was probably mishandled by yours truly along the way, but it sure looks like Series A and Series B both have held up in terms of deal count, while Series C and later is what has dropped off.

And for the valuations for Series B?  Well, it’s darn near impossible to get a read on this, for the obvious reason that no one reports valuations on venture rounds.  But we do have a very general indication from assessing round SIZE, which should be somewhat (weakly*) correlated to valuation.  And for Aug/Sept the median Series B round size in my dataset was $16mm, whereas for Oct/Nov it was $18mm.  With such a small data set that’s pretty fuzzy in terms of results, but at least what it DOESN’T show is some kind of dramatic contraction in Series B round sizes which might be a very loose indication of valuation decline.  Notably, the Aug/Sept Series B rounds included 5 rounds of $40mm or more, versus only 2 such rounds in the most recent period, so the mega-rounds might be taking a hit in particular…

It’s tough to draw too many hard conclusions from all of this amateurish and very quickly done analysis, but at least the above numbers don’t lend any credence to the idea that Series B rounds in cleantech are showing any overall decline in terms of dealflow or valuations.  Big-ticket rounds of any moniker, and Series C and later rounds, however, might be demonstrating some of what Bussgang is talking about…

3 and 4.  No question, everyone is thinking about keeping more reserves around for follow-on rounds for their companies, and I’ve spoken with several investors who are slowing down their new dealflow in order to keep their powder dry.  It does seem like entrepreneurs are having to work harder to pull syndicates together as a result.  So I think Bussgang’s spot on with his third point about the effects of a longer exit horizon in this regard.

But I don’t get why the companies will necessarily need more capital to reach an exit.  The aforementioned investors who are keeping their powder dry are doing so just so they don’t have to worry as much about an outside investor stepping up at the necessary time for a follow-on.  But Bussgang’s point about the startup themselves needing more capital (as opposed to existing investors putting in a greater share of additional required capital) makes the assumption that companies will be cashflow negative (in his back of the envelope calculations, it’s to the tune of around $10mm in net cash burn per year) all the way through to an exit.

But smart entrepreneurs are already figuring out how to get to cashflow breakeven as quickly as possible, if they’re not already there.  So I’m a bit confused by his example…

Both Bussgang and myself are engaging in nothing more than speculation at this point, and this is one of those things that will also be very case-by-case whereas we’re dealing in broad generalities.  Plus, his internet investment world looks different in several key respects from cleantech, in ways that mean we may both be right.  But I bet that when the numbers do eventually come out next year, we’ll see that 2H08 was a period of contraction in late stage cleantech venture capital, particularly for the really high-profile, high-valuation pre-rev deals… but much lessened impact on Series A and Series B.  How will that play in the headlines?  “Cleantech venture dollars take a significant hit!!!”  Hey, reporters gotta do what they gotta do.  But look at the details to see how it actually plays out.

(*My use of round size is a really desperate move, because obviously valuations shouldn’t really be tied to round size.  For example, if the Series B round sizes have stayed the same, but now they typically get 1/3rd of the company whereas they used to get 1/4th of the company, the analysis breaks down.  But on the whole, I think there’s some value in extrapolating based upon this data.  So reader beware…)

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