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Late Stage or Too Late?

The Boston Globe ran an article today about the venture capital environment and late stage VC investing.  Basically, because the exit environment is uncertain (very few IPOs, M&A exits are at low prices, etc.), companies are raising more late stage capital in order to remain private longer.  Although it can seem nice when a company raises a large round of financing (the companies cited in the article raised $40M+), it also changes the equation for everyone involved.

Even if these rounds are done at pretty high valuations, they still represent dilution for the management team.  And, for the existing investors, they have to commit capital to the company that they were hoping to keep in their pocket for other deals.  You can argue that this is balanced out by the ultimate exit being higher as the company will be even more mature, but I am skeptical of that for most companies.  The slow exit environment can also mean a slow customer spending environment, which can delay a company's growth.

Instead, many companies raise more capital than they should, which dilutes the exit returns for everyone.  What can you do about this?

The most important thing to do is to get to profitability as quickly as possible.  By being very cautious about what you spend and matching it with your revenues, you can minimize the amount of capital you need.  This will improve the investment return for everyone involved.  Of course, you shouldn't starve the company for capital, but it is much more common for VC-backed deals to be overfunded vs. underfunded.

The worst situation is the company where the investors are reluctant to put in additional capital because they don't see incremental return.  They are more likely to pressure the company to sell, even though it may not be the best time.  Being forced to sell a company too early can be discouraging for everyone, but, to the investors, it may make sense economically.  What can you do in this situation?  Make sure you don't get there by ensuring that your investors all have sufficient investment capacity for your deal, that they remain enthusiastic about your prospects, and that you carefully monitor your spending.  Am I sounding like a broken record?

I think that the late stage VC market is pretty challenging right now.  There is a lot of capital out there searching for deals, and valuations on good deals are going up.  With the exit environment remaining very tight, many good companies will struggle to raise capital because their company progress hasn't kept pace with their capital spending rate.  In other words, it's hard to justify further investment in the company as the upside looks limited.  Existing early-stage investors may be forced to provide additional capital to companies to keep them going until the exit window re-opens.  And, this is not helpful to entrepreneurs as they see their future returns going down.

The moral of the story -- spend slowly and get to profitability quickly.  That give you the most choices.  And, as a VC, keep plenty of dry powder and make sure your companies develop at a rate commensurate with their spending.

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