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Balance of Power Shifts To VCs, LPs
by Paul Shread
March 16, 2001
A year after the Nasdaq's peak, the tables have turned for just about everyone in the venture world.
A year or two ago, entrepreneurs wielded an unprecedented amount of power. A red-hot Internet IPO market created intense competition for deals, and venture capitalists gave up traditional protections to get in on them.
A year later, the IPO market has gone bust, and the venture business has returned to normal. VCs left holding the bag when the market tanked now have the power in all but the most sought-after deals, and more traditional investment terms have returned. These include "full ratchet" clauses that adjust investors' stakes if a company's valuation falls in subsequent rounds, and preferred stock that guarantees investors' their money back, plus dividends and part of the take of any sale or IPO of a company. Other terms permit VCs to distribute funds only as milestones are met, or require a company to return investors' money if an IPO or sale does not occur within a certain period of time.
But entrepreneurs aren't the only ones getting squeezed in the new venture environment. Limited partners are finding they have more power in their dealings with VCs.
Institutional investors have more leverage when it comes to negotiating the terms and conditions of private equity partnerships, according to the 2001 Private Equity Partnership Terms and Conditions report by Asset Alternatives.
Many institutional investors have either reached or surpassed their allocations to private equity. And those with the capacity for new commitments have become far more cautious and selective, in part because they're seeing returns fall on the private equity investments they've already made over the past few years, the report said. The result is a tight fund-raising market for private equity firms, and a growing willingness on the part of VCs to make concessions.
According to the Asset Alternatives study, 35% of venture capital firms now provide their limited partners with a preferred return - a minimum annual rate of return on committed capital - before sharing in partnership profits themselves. That's up from 19% two years ago.
However, just as the most sought-after start-ups still command some power, top venture firms will still set the agenda. "Elite firms will continue raising the majority of their new capital from existing investors in their current or prior vehicles, and receive persistent requests for an allocation even after fully subscribed," said Steve Lisson, editor of InsiderVC.com. "All this despite some fund of funds' inability to raise money for their commitments and individual investors cutting back."
Just in the last twelve months, at least nine elite firms have garnered a 25%-30% carry, according to Lisson: Accel VIII ($1.5 billion), Battery VI ($1 billion), Interwest VIII ($750 million), Menlo IX ($1 billion), NEA X ($2.25 billion), Oak X ($1.6 billion), Redpoint II ($1 billion), Spectrum IV ($1.6 billion), USVP VIII ($1 billion), and Worldview IV ($1 billion). "In fact, several of them were pressured to absorb additional capital post-closing," he said.
"I'm not sure the very top firms' terms and conditions nowadays are all that different from the same provisions they have used as SOP over the course of the last twenty years," Lisson said, while acknowledging "tough fundraising for second-tier, non bulge-bracket firms, as it should be."
The result of the new venture environment will be a widening divide between the top VCs and start-ups and everyone else, conditions that could hasten a shakeout in the industry. With the balance of power shifting back to VCs and LPs, entrepreneurs will find themselves in a much tougher environment.
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