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Double down? Spin in? New questions for a new economy

Double down? Spin in? New questions for a new economy

[Editor’s Note: We focus a lot on how hard it must be to raise money as a startup in this economic climate, with little attention paid to how agonizing it must be for VCs to pick and choose who is to survive. Below, Silicon Valley venture capitalist Bruce Cleveland offers his take on what firms are looking for, even though it might be too much to ask — including some thoughts on spin-in startups and how they could help get things moving.]

Every few years, venture capitalists like me have the tables turned on us. Suddenly, instead of evaluating investment opportunities, we become one ourselves — shifting gears to raise money for our next fund. Having just forged through this process for InterWest Partners‘ tenth fund, I’m pretty attuned to the scrutiny portfolio companies are forced to bear during this recent downturn. And the heat is definitely on.

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Clearly, early stage companies are going to be hit hardest. Mature startups know the ropes and pose less risk. It’s much easier to decide whether to invest in a company that is already actively growing its customer base and market share. But these days it’s harder for any startup to attract money from outside investors, no matter how many years it has under its belt. This is doubly bad for the youngest of the pack, which now have to raise even more at the outset to meet the stringent benchmarks required for the next round — and that’s skirting the issue that they’ll probably have to wait longer for that infusion regardless of what they do.

The critical factors for success are what they always have been: an experienced management team, a technology based on unique intellectual property, a growing market, and a compelling strategy. But now the bars on all counts are higher (and more challenging to reach).

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Take management for example. In a volatile economy, strong leadership is vital to success, but it’s also much less likely that the best people will jump to fledgling ventures. A good downturn manager has rarefied skills. He or she needs to know how to drum up more deals despite low cash flow, when to save, when to spend, and how to prudently cut costs without losing the faith of the staff. This kind of expertise comes through years of experience.

VCs are carefully watching how current portfolio companies stack up against these measures. When a growing market freezes up, many wonder whether or not to “double down,” or do more than they normally would to help struggling yet promising startups through the storm. When it comes to this, I know what I look for. Companies that develop, market and sell products that help other companies optimize their revenue. Some may think it wise to invest in technology that portends to help companies cut costs. But you’ll find that even in a recession, every company’s goal is still to make more money with fewer resources at hand.

You won’t see a lot of this doubling down if the IPO market doesn’t open up soon. It’s never been more important (or arguably as difficult) to grasp profitability as soon as possible. Those that achieve this milestone will control their own destinies, and will be that much closer to surviving through to an eventual upturn. Those that don’t will either fail outright or turn into easy acquisition targets.

Larger companies, which admittedly already have an easier time, have developed an interesting strategy to avoid this hurdle. It’s called the “spin-in.”

Typically, spin-ins are startups founded by people from a more established parent company. They usually work to develop products and technology aligned with the goals of the mothership, but keep track of everything (including venture capital raised) on a separate balance sheet. If certain technical milestones are hit, the spin-in is then absorbed back into the company, which it can then ride to profitability or leverage to raise further rounds. Cisco Systems has long been a major proponent of this strategy, and it’s clearly worked for them.

But there’s also another way to do it. A spin-in doesn’t have to be a simple technology play. Instead, the parent company works with investors (since it has the clout) and the management team to build a real company with real revenues of its own. That way, if it gets gobbled back up after two or three years, it can be immediately accretive to the parent company. This is an attractive option for bigger companies looking to balance their investment in innovation against dilution of corporate earnings. Not to mention that it will help both venture firms and management teams address the issue of liquidity in a world where IPOs, mergers and acquisitions are becoming few and far between.

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It’s this brand of creativity (paired with disciplined execution) that will see some shaky operations to the end of the tunnel. In that light, I wouldn’t be surprised if the market leaders of tomorrow emerge from this downturn with different values and sharper tools — and that could be the best thing for the market yet.

Bruce Cleveland is a partner at Menlo Park, Calif. venture capital firm InterWest Partners. Previously, he was one of the first executives at Siebel Systems. He blogs at Software-as-a-Service.

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