I had an interesting conversation yesterday with a good buddy of mine who works at a top venture capital firm. I mentioned that Locust Walk Partners is considering doing company formation work. I wanted to know if he thought that we were crazy. He responded that he actually is spending a lot of time these days on company formation. During the conversation he also discussed why they decided not to make a follow-on investment in a company, and that they were subsequently converted to common. He also talked about completely dysfunctional boards and syndicates that cannot agree on anything, and as such companies make poor choices. How does this all fit together?

Follow-on investments in current portfolio companies might be throwing good money after bad (note: not all follow-ons are a waste of money and winners should be continued). The valuations of most current portfolio companies funded more than a year ago are overvalued given this environment. Short of recapping the company, insider rounds are only going to make the problem worse by increasing the valuation, generally at a flat price. Bruce Booth at Atlas Venture eloquently demonstrated in a Nature Biotech article that the intuitively obvious observation that more money invested and thus higher valuations leads to lower returns. LWP is about to unveil an analysis that says that much of the funding these days in existing companies, not surprisingly is insider rounds. Getting a deal done today with an external investor is extremely difficult for a host of reasons. Many of these outside investor deals where the new investor prices the round need to be done at a down valuation. There clearly are political implications of doing this. So, what is the answer?

Company formation is the only way to control the valuation, get founders shares in addition to preferred stock, control over the selection of the management team, control the venture syndicate and dictate the terms for the Series A round. While some venture funds have been successfully doing this for a while, others don’t think it is worth their time. I postulate that in this venture market, VCs should be working on funding more new companies with innovative technologies, not mee-too retreads further in development. Maybe VCs should even consider reallocating to start-ups some of the recently increased allocation they “reserve” for current portfolio companies. A recent webinar given by ReCap stated that they think that the shift among buyers (big pharma/biotech) will be from the late stage, which are very picked over, to collaborations earlier in the development cycle, including research and pre-clinical stage. Sounds to me like a great opportunity worth pursuing!