Venture capital feels the heat from dotcom turmoil

Posted at 08/16/2012 12:36 PM | Updated as of 08/16/2012 12:36 PM

SAN FRANCISCO - As consumer Internet shares plummet, venture capital firms find themselves fending off increasingly uneasy investors who are urging them to cash out after millions -- and in some cases, billions -- of dollars evaporate from holdings.

Rapid declines in once-hot names ranging from Facebook and Groupon to Pandora and Zynga are putting some strain on VCs' relationships with their own investors, who do not often pick up the phone and weigh in with their opinions. Now, the calls they do get tend to focus on that group of high-profile companies, investors and VCs say.

On Tuesday, many again got walloped. Daily-deals site Groupon lost a quarter of its value after posting dismal results, bringing its total loss in market value since November to more than 70 percent, or $9 billion. Social network Facebook shed 6 percent and is now about half its value at debut.

At a company's initial public offering and then again about six months afterward, venture backers are free to sell or distribute shares to their own investors, known as limited partners. But many hold on for months or sometimes years, leaving millions on the table when compared to the companies' rich prices at IPO.

"We don't pay you to hold on to a public stock," said Chris Douvos, managing director of fund-of-funds service Venture Investment Associates and a former manager at Princeton University's endowment.

The situation reminds him and others of the 2000 bursting of the dotcom bubble, when limited partners' paper profits in companies that were long on buzz and short on business models dissipated at a rapid clip -- memories that could encourage limited partners to do some lobbying.

For endowments that spend based on the value of their portfolios, "you've spent paper profits, which have now disappeared," Douvos said. Still, the impact is usually just a fraction of a percent of the endowment.

Venture capital funds invest in stages over many years, so it's difficult to estimate changes in the value of their holdings. Many likely made big profits on the dotcoms given the low prices they invested in initially, but the recent selloffs are compressing those returns.

As of Tuesday's close, Kleiner Perkins Caufield & Byers has seen its investment in gaming-company Zynga dwindle by $450 million since its IPO.

Accel Partners, which won acclaim for being among the first to back Facebook, has nonetheless lost more than $2 billion on paper in three months.

Greylock Partners still holds 9.6 million shares in music-service Pandora; NEA holds 87.5 million shares in Groupon; Kleiner retains all its 65.2 million shares in Zynga; and Accel owns 152.3 million Facebook shares, filings show.

Greylock, NEA and Kleiner declined to comment on specific holdings. Accel didn't respond to a request for comment.

A DELICATE SITUATION

The situation underscores the delicate relationship between venture capitalists and the investors or limited partners they rely on. While the latter put in the hundreds of millions of dollars that make the funds possible, venture capitalists make the calls on what to buy, which companies to nurture, and when to exit.

Now, with many high-profile consumer Internet companies well off their debut levels, many venture funds are holding stock worth as much as two-thirds less than at the IPO.

On Friday, some of Facebook's backers will be able to sell stock for the first time since its rocky May IPO. But many others are stuck at least until November, the six-month lockup's expiration. At current levels, investor holdings are worth little more than half what they were at the IPO.

That's in part why many are fielding phone calls from their own investors who are ruing what they see as a missed opportunity. "Hey, was hoping to see a few more of those Facebook shares!" one major backer of the company said a typical call might go.

A handful of firms, such as Kleiner and Sequoia, typically do not sell shares at an IPO. Others might sell around 10 to 20 percent of their holdings. After the lockup period, firms typically make distributions periodically, either by giving shares back to investors or selling stock and doling out cash.

With many top funds turning away investors, some venture capitalists believe investors are lucky simply to be included and should not butt in with their opinions on when to distribute. But some limited partners see it differently: they handed over millions, and the venture capitalists should take their calls.

"They're not looking for our input," said Mike Kelly, managing director of the investment committee at Hamilton Lane, a fund advisory firm that invests on behalf of clients in various venture-capital funds. "But if you have a good relationship with them, they'll listen."

He and many other limited partners typically push for exits as soon as possible after the IPO, in part because of the fee structure at venture-capital funds.

Venture funds typically take a 2 percent management fee based on the total fund size, plus 20 percent or more off of gains. That's in contrast to the few percentage points limited partners might pay to firms that manage public-company investments.

Strategies on how long to keep the shares post-IPO vary widely from firm to firm.

Those who like to hold longer-term say that is a selling point that wins them access to the best-performing private companies, which often attract swarms of would-be backers.

"We have a long track record of holding and even buying more shares in our companies post-IPO," said Glenn Solomon, a partner at GGV Capital, which hasn't sold any of its shares in Pandora.

"Growth stage CEOs know this, and it's often one of the reasons they choose to work with GGV."

Sticking to their guns can also work in their favor. Take professional-networking company LinkedIn, which listed at $45 in May 2011. Venture backers Bessemer Venture Partners, Greylock and Sequoia Capital sold no shares at the IPO, leaving them better positioned to reap further gains as the stock appreciated. LinkedIn is now trading north of $100.

Many firms like to sell or divest over time. Walden Capital has been distributing Pandora shares back to investors at a steady clip of around 1 to 3 million shares roughly every couple of months since January.

"We've pursued a very thoughtful, careful, slow approach of divestification to avoid any shocks to the stock," said Larry Marcus. "We're a very strong, long-term believer in the business."

Of course, like most venture investors in social-media stocks, he and his investors made a tidy profit, despite stock drops. Walden's average cost for Pandora was under $1 per share, Marcus said. The stock, which debuted last year at $16, is trading in the $9 range.

Still, even if the investment in the company overall represents a big gain for the venture firm, losses post-IPO can detract a tad from the acclaim.

Accel's remaining shares in Facebook are worth roughly $3.1 billion now, compared to $5.79 billion at IPO. NEA's stake in Groupon is worth $481.9 million, versus $1.75 billion at IPO. And Kleiner's Zynga stake is worth $195.6 million, from $651.6 million at IPO.