Patient Capital Gets Rewarded

Brad Feld threw out something in his post on Net Sec being acquired by MCI that I’d like to take and run with.

Brad said:

One of the key themes that has been floating around recently in the venture business is that the patient capital through the downturn (e.g. folks that hung in there with solid businesses in 2001 and 2002) is starting to be handsomely rewarded for their perseverance.

There were two kinds of VCs operating in the bubble years.  There were the traditional VCs who’d been investing for a while before the bubble hit, and there were the newbies; corporations, first time funds, individuals, buyout firms, hedge funds, etc that quickly got into the venture game when they saw the opportunity to make big hits.

When the bubble burst, a predictable thing happened.  The newbies ran for the hills and the real venture guys hunkered down and dealt with the carnage in their portfolios.

It wasn’t fun, it wasn’t easy, and it wasn’t immediately obvious that hunkering down was the right choice.

It is now.

If you look deeply at most of the companies that have been sold or taken public in the upswing that started in the spring of 2003 you will see a story of big winners and big losers.  Most of these companies were started in 1999 and 2000.  Most of them had a big syndicate of investors.  Most of them did a recap (or two or three) in 2001 and 2002 which wiped out some of the investors and gave the investors who participated in the recap big slugs of the equity at very low prices.

And when you calculate the gains, the investors in the recaps are making 5-10X on the new money they put in and at least 2-3x on their total invested capital.  The investors who ran for the hills have lost everything.

Brad mentions Service Magic and Net Sec in his post.  I’d be curious how those situations played out.

But I’ll give you an example of our own and we have at least four or five to date that fit this story and a bunch more on the way.  I’ll go with one where the information is public and easier to disclose.

We participated in the seed financing of a company called Portal Player (ticker symbol PLAY) in the fall of 1999.  The Company did a full blown venture round in Feb 2000 where a bunch of new investors joined the syndicate.  That round was done at a stepup to the seed round.  We participated in that round for the same amount we put into the seed round.

Portal Player was the first company to identify the market for chips for portable media devices with hardisks (ie the iPod).  It was doing great engineering work, but the market wasn’t developing nearly as fast as we had all hoped.  And we had all of the normal growing pains in our management team.

So we had to put more money in.  And we did, again and again and again.  From December 2000 to February 2002, we did four insider financings.  Each one was brutal and everyone was questioning the wisdom of pouring more money in. All of these rounds were some form of recap where the investors who didn’t play got wiped out.  And by February 2002, there weren’t many of the initial group left.

But by then, it was clear the company had something.  And so some new investors got interested.  And in the spring of 2002, a big recap got done that allowed the investors who had been hanging in throughout the tough times to maintain most, but not all, of the value of their prior investments.

In the fall of last year, Portal Player went public and is trading north of $20/share.  The early money is basically worthless, but the money we and others put in between December 2000 and February 2002, has made about 5x its money at current market prices.

What’s interesting to me about this story is that even with the wipeout of the early money, our total return on the investment at current market prices is around 3x, which is, in my experience, about an average venture return.

I think this is the story of the venture market of 2001 through 2003.  Those who hung in and supported the good companies in their portfolios are getting "rewarded hansomely" (Brad’s words) for their efforts.  And I think this will result in many of the 1999 and 2000 vintage funds returning the committed capital plus a small return to their limited partners. 

It will take some more time and the final chapter won’t be written until the end of this decade (venture funds are normally ten year funds for a reason).  But that’s how I think it will play out for the good firms in the venture business.