As previously reported, company valuations have decreased significantly. And venture investing is (as most businesses) essentially about selling something (in this case shares) with a margin large enough to compensate for risk and cost.

So, is not the current situation a great opportunity to invest in? It is, or at least we (and many other investors) think so.

But why then is VC investment activity going down instead of up? Well, I’ll try to pinpoint a few reasons and their implications from a VC perspective:

Lack of capital

Many VCs don’t have capital available for new investments. This is true both for VCs investing from their balance sheets (common for strategic/industrial investors) and for VCs investing through a fund structure where investors (Limited Partners) commit a certain amount of money over the fund life cycle, typically 10 years.

And currently it is very difficult for VCs to raise more money due to a number of reasons:

– Price of risk has increased: LPs are less inclined to invest in perhaps the riskiest of all investments types, namely early-stage.

– LP allocation: LPs often allocate a percentage of total investments to alternative (e.g. venture capital) investments. So, when the value of the other investments (e.g. public stocks) decreases, the percentage allocated to venture capital translates into a lower absolute number.

– Venture capital has in general not provided good enough returns: (read for example Fred Wilson’s excellent blog post on this topic). This makes LPs hesitant to invest in anything but the best VC firms (as seen Index didn’t have problems raising a new fund).

– LPs lack capital: Although LPs have committed money to the VC funds, the money is often held in some asset class (stocks, bonds etc) until called upon by the VCs. Unfortunately, with the current situation some LPs are having problems to actually free up enough capital to match the VC’s call for money.

Recession and refinancing risk

Due to the recession and the financial crisis, many portfolio companies are facing a much tougher situation than 1-2 years ago. Therefore, VCs need to spend more time (and money) on their portfolio companies due to decreased customer demand (deals take longer or even get cancelled). There is also the refinancing risk meaning that VCs have to put more money into the companies, money that previously could come from e.g. banks or other investors.

This situation is of course also true for companies that VCs are thinking of investing in. The way to address this is typically to find strong co-investors (called syndication) already from the beginning so that the investors can support the companies longer without having to count on money from banks or new investors.

All this means that there are fewer VCs with capital to invest, which coupled with an increased need to co-invest to handle the increased risk means that fewer companies end up receiving financing.

Low valuations

Actually the low valuations also represent a problem in itself. Firstly, lower valuations make it more tricky to make good exits which means that VCs need to hold on to existing companies for a longer time (again often requiring more time and money). Secondly, the lower valuations create problems for entrepreneurs and investors to make deals, since the entrepreneurs may not be willing to accept a lower valuation just because the economy in general is in a sour state.

UPDATED: And then the South Park take on it…