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Tech Industry

Tech execs backing out of VC pacts

Hard economic times are inciting once-wealthy "hobby investors" to sell their interests in venture capital funds to escape the long-term financial commitments they have made.

Hard economic times have led some one-time successful Internet executives to try to sell their interests in venture funds, even at a steep discount.

Once awash in cash, these "hobby investors" are increasingly finding themselves financially tapped out and wanting to get out of long-term financial commitments made to venture capital firms.

"Last year, I got a call from an investor about once every six months," said Jerold Newman, president of New York-based Willow Ridge, which buys out private equity interests in a venture fund. "Now, I get about four calls a month from people who want to sell me their interest in a VC fund."

Financially, individual investors play a small role in the venture capital community. Of the nearly $93 billion raised by VCs last year, just under 12 percent came from individual investors, according to Venture Economics/Thomson Financial. Most funding comes from institutional investors such as pension funds or foundations, along with corporate investors.

But individual investors--frequently entrepreneurs who are actively involved in their industry--are important to venture firms for their ability to refer other companies as potential investments.

"Virtually all deals come through referrals," said Anthony Romanello, investment analytics manager with Venture Economics. "Over the last few years when things were moving at a frenetic pace, a lot of executives and entrepreneurs were invited into funds by VCs. Now the pace has returned to normality, and it's a wash whether their contribution will be missed."

During the technology boom, it was not uncommon for entrepreneurs suddenly flush with cash and soaring stock holdings to hook up with venture capitalists--many of whom helped fund the entrepenuers' companies and made them rich in the first place. As investors, these people committed to putting up millions of dollars toward venture funds.

A trend coast to coast
Now Willow Ridge and other so-called secondary firms, from New York-based Venture Capital Fund of America to Paul Capital Partners in San Francisco, are all reporting an increase in the number of individual investors seeking a buyout.

"Historically, we mainly received (buyout) requests from institutions, but lately we've seen a lot of interest from CEOs and entrepreneurs, especially from tech companies," said Bryon Sheets, a partner with Paul Capital. "They made their VC commitments when their paper profits were robust and now they're looking in every corner for liquidity."

Hobby investors
Although individual investors comprise a small portion of the money raised for venture funds, their slice of the pie grew last year.

Year Total capital raised Percentage
  1996

    $11.8 billion     6.8 %  
  1997

    $17.1 billion     12.5 %  
  1998

    $29.4 billion     11.3 %  
  1999

    $60 billion     9.6 %  
  2000

    $93 billion     11.8 %  
Source: Venture Economics/Thomson Financial
Traditionally, investing in a venture fund was understood as a high-risk, sophisticated gamble for wealthy people who knew the ins and outs of the financial world. An investor promises the funds, and the venture firm simply notifies investors to pay portions of their commitments as the firm makes investments into companies.

Individual investors often commit anywhere from $500,000 to $10 million to a fund, secondary firms say. And if they cannot meet their obligation, there are few options.

They can default--but they risk losing some or all of the credit they have received toward their overall obligations. That becomes important when a fund gives money back to investors as the portfolio companies are sold or go public. Investors who have not fulfilled their commitments have to apply any money received toward their outstanding bills.

For example, an investor who has paid $3 million of a $10 million commitment could see a credit drop of $2 million if he or she defaults on the VC's request for that amount. If the investor misses another $2 million request, the credit could be totally wiped out and the investor would not get a dime of any profit the fund generates--even though he or she paid $3 million.

As a result, a buyout can be a more appealing option.

"Usually a (venture firm's) general partner will try to find a buyer," said Brett Byers, general partner with Venture Capital Fund of America. "They might buy out the interest, or another limited partner may buy them out."

The down side
But there are drawbacks, from investors being forced to sell at a discount to souring their relationships with potential partners.

Jon Staenberg, managing partner with Seattle-based venture firm Staenberg Venture Partners, said he had a limited partner change his mind about selling his interest after a firm offered to buy it at a 50 percent discount.

Those steep discounts can also hurt the fund or the firm backing it.

"It can create an investor relations issue for the general partner if they report the fund is worth X and someone comes along and buys it for substantially less a few weeks later," Sheets said.

Staenberg said the close personal ties between the partners can also cause problems.

"It can be an uncomfortable conversation. In our case, many of our limited partners are my friends, and it's uncomfortable to think I may have to say 'no' to them," Staenberg said. "Also, if you allow one investor to do it, the others may begin asking about it. I'm already pressed for time, and I'd rather focus on the companies we're working with and investing in."

But that works both ways, considering many investors owned or ran companies once funded by the firm. If they sell their interest, they may find it harder to get future funding or risk being shut out from joining venture funds later when economic times improve.

"A lot of individuals were invited into funds (by VCs) on a selected basis to add strategic value to the general partner's fund," Sheets said. "And if the limited partner wants to exit, it's embarrassing to the VC and may affect that limited partner's relationship with them."