New York Comes to Silicon Valley
Look to recent funding deals for Ning and Slide to see evidence that Wall Street may be cutting out the middleman—venture capitalists
The relationship between the venture capitalists of Sand Hill Road and the securities firms and power investors of Wall Street has long been a cozy one. VCs hoping for a return on their investments will need banks eventually, while Wall Street needs VCs to nurture the most promising startups until they’re ready to go public.
Or do they?
Lately, some of New York’s biggest players have been cherry-picking the best pre-IPO investments for themselves. Marc Andreessen’s Ning was recently funded by Legg Mason (LM), T. Rowe Price (TROW), and Ziff Brothers Investments for a valuation of more than $200 million. Max Levchin’s Slide got $50 million from Fidelity Investments and T. Rowe Price, conferring a $550 million valuation on the maker of widgets for social networks (BusinessWeek.com, 1/18/08).
Predictably, pundits wrung their hands over sky-high valuations—missing entirely the real cause for alarm among Silicon Valley’s blue-shirt-and-khaki set: Wall Street is putting the squeeze on an already troubled VC community.
The VC Squeeze
If you’ve read anything I’ve written in the past eight years, you know I think the venture capital industry is in a bad way (BusinessWeek.com, 10/3/07). The calamity comes as ballooning global pension funds seeking better-than-broad market returns meet up with venture capitalists eager to fund the next Bill Gates, Steve Jobs, or Mark Zuckerberg (Facebook’s founder)—helping to create an entire asset class out of what probably should have remained a subset of niche investments.
The upshot: Very few firms are making so-called venture-style returns on all that money sloshing around Silicon Valley. Sure, last year’s initial-public-offering and acquisition numbers look good in the aggregate, but when you consider the time and money needed to birth all those “successes,” there were precious few home runs—and a lot of portfolio losses. Outside the handful of VCs that generate 90% of the industry’s returns, a lot of firms are struggling to stay viable.
VC life was already complicated by the so-called angel investors capable of parking big bucks in promising early-stage companies. A lot of hot startups are getting funding early on from angel investors who made their fortunes in the late 1990s. That, along with dramatically lower startup costs, means VCs are forced to buy in when the company is more mature and their funding brings far less ownership, and entrepreneurs are able to retain control in ways rarely seen in the Valley.
And now, thanks to Wall Street, VCs are also getting squeezed at the late-stage end. If even early-stage companies aren’t buying the mantra that VCs add value, provide guidance, etc., then surely a later-stage Web company that’s already reaching a large, valuable audience won’t. And as the Ning and Slide deals show, banks will almost always offer larger valuations—and meddle less.
An Elite Club
For Silicon Valley, the pinch may only worsen, thanks in large part to the efforts of Allen & Co. The New York firm is the expert matchmaker putting together name-brand entrepreneurs with a bank that wants them so bad, it’ll seemingly pay any price. Allen & Co. is heavily relationship-oriented, inviting the cream of the high-tech and media crop to its swanky Sun Valley Media Conference every summer. Where else can a young hotshot founder rub shoulders with Gates or News Corp.’s (NWS) Rupert Murdoch?
But don’t ask the notoriously media-shy Allen & Co. to weigh in on its power-brokering ways. Neither anyone at the firm nor those who do business with Allen & Co. would comment for this column. Last summer I asked a close friend of Allen & Co. if there was any way I could weasel my way into the conference as part of reporting on my book. “Few things in life are impossible, other than walking through a revolving door with skis over your shoulder and this,” I was told. Put another way, I found this July e-mail by searching my inbox for the words “no way in hell.”
Allen & Co. isn’t entirely a black box, and Silicon Valley does well to understand how it works. While much of chummy Sand Hill Road runs on gut feeling, Allen & Co. relies more on armies of MBAs crunching numbers and running models. The firm does the hard work, finding and courting entrepreneurs, putting them through a due-diligence gauntlet, and then picking up the phone, calling a big institutional investor, and delivering a handsome investment package.
Wall Street institutions love this model for a few reasons. Instead of trying to cram more money into the few truly rock-star venture firms, they can go directly to the hottest companies. If the deal hits, they walk away with a bigger slice of the proceeds even if they have paid a higher valuation, all the while avoiding paying millions of dollars in “management fees” and absorbing losses on the inevitable dogs in a VC’s portfolio. If it misses, big deal. What’s $20 million in a startup compared with $1 billion of Google (GOOG) or Yahoo! (YHOO) stock?
Besides, with markets in turmoil, a modest investment in a private company that won’t go public for a few years represents a relatively safe bet. Even if values decline, the investment won’t have to be marked to market on a quarter-by-quarter basis.
However eager these non-Silicon Valley investors may be to get a slice of Bay Area action, they’re not throwing around money with no strings attached. Wall Street banks aren’t going to be happy with a modest acquisition. If they’re investing at these kinds of valuations, they expect a big swing-for-the-fences IPO at some point. It can take a few years, but there better be a big pot of gold somewhere.
What’s In the Stars?
And not all of these East-meets-West Coast deals are structured the same. Shakier startups too are raising money from institutions, sometimes at terms that are far harsher. I doubt No. 2 widget maker RockYou gets close to the same terms as its larger, star-studded competitor Slide. The companies that can demand the sweetheart deals need to have a great story and some serious star power. Would Ning be worth $250 million without Andreessen? Doubtful.
That means we may not see many more deals like the ones Ning and Slide closed. But the threat these banks pose to investors isn’t about the volume of deals they’re scooping, it’s about seizing the best ones. In the case of Ning, Andreessen took some money from angels, but largely bankrolled the company with $9 million of his own money until he raised money via Allen & Co. VCs never had a chance. And Levchin also funded Slide on his own, in addition to tapping friends and investors from his PayPal days. There was one true venture round for Slide, and even the legendary Vinod Khosla of Khosla Ventures had to fight to get in.
There’s only one thing worse than VCs getting pushed toward later stages of investment—and that’s not getting to invest at all.
Lacy has been a business reporter for 10 years, most recently covering technology for BusinessWeek. Her book, Once You’re Lucky, Twice You’re Good: The Rebirth of Silicon Valley and the Rise of Web 2.0, will be published by Gotham Books in May, 2008. She is also Silicon Valley host of Yahoo Finance’s Tech Ticker.