There is one topic on the minds of all entrepreneurs right now: the impact of the economy on their startups. The economy is the centrepiece of every networking event and panel, and it even consumed the Q&A session after my speech at VANJ last week on how to raise VC. It’s inescapable.
The financial crisis has and will continue to effect the venture world. Despite how bad things have become, however, there is a silver lining for the best startups. Here are my thoughts on the good, the bad, and the ugly of the current economic environment.
The Ugly: Economy In Shambles
We all know how troubled the financial markets are right now. The public markets are in an irrational downward spiral, the gears of our credit machine haven’t unlocked despite being greased by the government bailout and the exit environment is as slow as it has been anytime in the last 30 years . In a nutshell, our economy is undergoing a substantial realignment that is leaving the weakest to be killed off quickly by the consummate predator – the global financial community (Thomas Friedman’s so-called “electronic herd”). The casualties have included most facets of the American economy, including financial institutions (Bear, Merrill Lynch, Lehman, WaMu), big corporations (Automakers, Linens ‘N Things, Circuit City), millions of households and, yes, the government, which is watching corporate tax revenue evaporate while the cost of providing life support to the ailing economy is climbing.
The Bad: Venture Market – An Innocent Bystander
While the industries in which venture capital firms traditionally invest (IT, life sciences and, more recently, clean technology) are not directly in the line of fire of this economic downturn (as they were in 2000), the venture space has and will continue to be adversely affected.
An investment banker I know recently stated his view that it will take at least six months for our economic wizards to be able to quantify the size of the financial correction; we don’t even know how bad it is yet. Uncertainty drives corporations and consumers alike to hedge all bets by cutting their spending on everything from advertising to autos. As pockets tighten, it becomes more difficult for companies (whether B2B or B2C) to generate revenue, creating the need to reduce costs or take more capital from investors.
Unfortunately, right when companies need the investment community’s support, venture purse strings will be tightening. There are a few reasons for this conservatism. First, later stage investors (the growth stage venture firms) know that companies that they invest in today won’t be able to exit as quickly as they once might have because the public markets are sick and the corporate buyers are conserving cash until they understand how bad things are going to get. An increased time to exit means lower effective returns.
Second, many VCs expect growth stage capital to become less accessible (for the reasons described above) and, as a result, are increasing their capital reserves for their portfolio companies. VCs hope to fill part of the follow-on financing gap, enabling their companies to stay afloat while holding out for growth capital. While this is good for portfolio companies, it does mean fewer deals in the portfolio. VC funds are fixed in size, therefore allocating more to each company generally means fewer new investments.
Third, some limited partners (the investors in venture funds) are reducing their allocations to venture capital, despite the fact that venture capital traditionally performs well in recessionary market environments. With the net asset value of nearly all liquid assets devastated by the market crash, many limited partners are now experiencing what is being referred to as the “denominator problem.” For example, if an institution had originally planned to have 10% of its assets in venture, the decline in value of the other 90% of its assets effectively increases the percentage of the portfolio that venture capital represents. An LP may have seen the percentage of his/her assets in venture capital increase from 10% to 14%, leading him to pull away from the very asset class that is likely to provide the best returns in this environment. The magic of this maths is that it encourages LPs to invest more in the most troubled asset classes, not the healthiest. While some LPs will follow this logic and cease to make investment in venture until the value of their other holdings rebounds, others will invest more in venture because the fundamentals of the venture sector are even more attractive now. Without new commitments from LPs, there will be less fresh capital coming into venture funds. The net effect is likely to be fewer investments at all stages of the venture market.
In sum, revenues are going to be lower and less capital is going to be available. This of course leaves entrepreneurs with one option: reduce costs. Coincidentally, reducing costs often means making layoffs, exacerbating the downward spiral of consumer spending. It’s hard to buy Christmas gifts without a job. Additionally, the decline in capital means that valuations will drop substantially–a trend that is already visibly taking hold in the market. Times in the venture world are challenging. As any good entrepreneur knows, however, change creates opportunity.
The Good: The Weak Will Die Quickly; The Strong Will Win Big
In this new economic environment, access to capital will become an increasingly important differentiator. If venture investing contracts substantially, a strong balance sheet will no longer simply be a means of staying with the pack, it will increasingly become a substantial advantage, enabling some companies to get way out in front of their competition. While many startups are deploying limited resources, trying to manage costs and weather the storm, the few well capitalised players in each market segment will be positioned to invest for the future, laying deep roots into their markets that can support rapid growth with the drought ends. Furthermore, as layoffs continue to take place at the corporate giants (such as American Express), startups that are well capitalised will have an opportunity to hire high calibre people now looking for work, increasing their advantage and mitigating the human capital constraint that traditionally plagues new ventures in booming economies.
This is a virtuous cycle for the winners. As competition becomes more polarised, the leaders will eat even more of the laggards’ lunch making it even more difficult for the back of the pack to compete. Customers naturally gravitate towards the financial stability of the winners and in tight economic times the second tier players may not be able to reduce their margins to win over the more price sensitive buyers, limiting their means of catching up. These dynamics will likely kill the weak off more quickly, enabling the winners to more quickly separate themselves from the pack.
While I believe the frontrunners will come out of this downturn positioned to win big, the story isn’t entirely bleak for the second and third tier players. Once the end of the downturn is in sight, corporations will likely exploit the financial woes of startups to make low cost acquisitions. The hunters will be coming. For some entrepreneurs this could yield decent (if not life altering) returns.
There is no doubt about it—times are tough for the overall economy and that has, and will continue to, impact the venture marketplace. The companies that are not going to succeed will likely discover their fate more quickly (a blessing in disguise), the companies that might have otherwise squeezed by in a better economy should be sure the corporate sharks smell their blood and the winners should be opportunistic and cautiously thinking big. In sum, I think it’s a great environment for the best entrepreneurs. While at today’s valuations it will likely cost founders a pound of flesh to acquire the capital they need to win, they’ll be able to turn a pound of flesh into a mountain of gold.
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