Startup Investment?

April / May 2008 By: Dean Takahashi Volume 6 Number 2

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The malaise in the housing market is likely to impact the innovation market. There's no easy way around that. A problem in one sector of the economy will spill over and cause a chain reaction, once it becomes big enough.

The crisis on Wall Street has hit big investment banks hard. Private equity firms can no longer borrow so much money to take over struggling public companies. The public tech companies may find that Wall Street banks are no longer buying lots of equipment. Those public tech companies won't have as much money to spend on acquisitions. That could drive down prices for startups looking to be acquired. That, in turn, might discourage venture capitalists from taking the biggest bets. It's a kind of vicious cycle.

There are some who would argue the sky isn't falling. But the fanciful hopes that the credit crunch would be short lived are no longer realistic. Those who look at the glass as half full say that a recession is the best time to start a company. That's because the company won't have a product to sell for a couple of years anyway. By that time, the recession will be over. Meanwhile, everything the company needs to acquire—€”employees, resources, real estate—€”in order to get off the ground are cheaper. The companies in the earliest stages are thus able to "fly over the storm," says Thomas Cole, a general partner at Trinity Ventures in Menlo Park, Calif.

But at some point, if the woes are big enough, everybody takes a hit. The Nasdaq stock market is down about 15 percent this year, but the overall markets have been roiled with volatility thanks to the collapse of Bear Stearns & Co.
According to the National Venture Capital Association, only five venture-backed companies have had an initial public offering in 2008. Only one of those was in Silicon Valley, according to Renaissance Capital. There were 31 IPOs in the fourth quarter of 2007. The level of IPOs in the first quarter was the lowest number since the second quarter of 2003.

On top of that, the trouble among public companies and private equity firms has caused them to pull back on acquisitions. There were only 56 venture-backed merger and acquisition deals in the first quarter, compared with 83 in the fourth quarter of 2007. The number was one of the lowest quarterly levels in the past decade.

Angel investors have also become more cautious because of economic volatility, according to the 2007 Angel Market Analysis released by the Center for Venture Research at the University of New Hampshire. That's significant because angels account for 39 percent of seed-stage startup funding.

And the Silicon Valley Venture Capitalist Confidence Index fell to its lowest level in the past four years in January. The index tracks the confidence among venture investors and it hit the lowest level since its creation in 2004.

"This plunge in venture capitalists' confidence is unprecedented in the four year history of this quarterly index and portends an uncertain high-growth venture environment in the Bay Area over the coming months," the report said.
"As might be expected, concerns related to financial market turmoil and, specifically, the credit markets, were cited as a primary cause for lower confidence. Worry over a general economic slowdown that would negatively impact the high-growth venture environment was also expressed."

It's noteworthy that the gloomy index result predated the collapse of Bear Stearns. VCs are still evaluating the impact, but early hopes that there would be no impact are disappearing. The lesson of the 2001 to 2003 bust was that VCs who over-invested or under-invested during the time of fear or the time of greed were hit the hardest.
"It's early to judge the economic issues and their effects on venture funding," said Deepak Kamra, a partner at Canaan Partners. "It took a year for expectations to come down the last time around. Valuations stay where they are and people hope there will be no slowdown."
Jason Green, a partner at Emergence Capital Partners, agreed that valuations have held up so far in the deals that he is evaluating.
"I'm fairly bullish," he said.
But Gus Tai, a general partner at Trinity Ventures, acknowledged that the environment has changed. During a recession, venture capital companies and startups do suffer.
"Companies have to change plans," he said. "Valuations tend to come down."
Tai believes that consumer spending has to slow down. With a negative savings rate, he says that consumers still continued to spend, but mainly on the strength of home equity borrowing. That is likely to come to an end as a result of housing devaluations and the end of easy credit. On top of that, he said that large companies will be more cautious with their spending. Smaller companies would be wise to draw down additional funds, or tranches, on previously raised rounds.
"Smart companies are battening down the hatches now," said Cole at Trinity Ventures. "If they can raise more money, they will. That's like putting more gas in the tank."

If the environment becomes worse, then it becomes a matter of which categories will get hurt more than others. Social networking has been a hot category ever since Google bought YouTube for $1.6 billion in 2006. Then Microsoft invested $240 million in Facebook last year, giving the social-networking site a valuation of $15 billion. AOL recent agreed to buy social networking site Bebo for $850 million.
But Seth Goldstein, CEO of social application network firm Social Media Networks, said that he is less optimistic. He said the sale of Bebo for $850 to AOL may mark the peak of the social networking valuations, given the current decline in optimism about the economy.
"VCs are cutting down funding and exits will be suboptimal," he said.
It isn't the end of the world if venture capitalists don't fund more social networks. But the strongest social networks such as Facebook and MySpace are still expected to find business models that allow them to cash in on their tens of millions of users.
Ryan Floyd, a partner at Storm Ventures, said that the economic malaise has so far only hit financiers at the top of the food chain, such as private equity firms. He thinks it will take a while before it trickles down to venture funds. If the economic downturn lasts, however, then the impacts start multiplying as big businesses pull back on taking risks and consumers stop spending. The big companies are reexamining their expenses and banks on Wall Street are now expecting that their IT spending will be down 10 percent. That leaves them very little leftover discretionary spending to spend on startup products. Once the malaise spreads, he doesn't think there will be any safe havens.
"Some people subscribe to the theory that there are defense strategies you can pursue," he said. "They have had theories that technology is immune from recessions. It's a way to reduce your operating expenses and reduce costs. I don't subscribe to that school. At some point, you have to realize that when times are bad, they are bad for everyone. Everybody gets caught up in it and can't escape."

Companies looking for exits in 2008 have a bleak outlook, he said. At the same time, Floyd says that he doesn't take the economy into account when considering early stage deals where the product won't be available for years.
"The economy isn't stopping me from making those investments now," he said.
Clint Chao, a partner at Formative Ventures, said that companies that use technologies from government labs continue to be attractive because the government researchers invest most of their time in proving out a technology. Spinning that technology out to a startup can give that small company a leg up, he said.

Jim Perkins, CEO of Radar Group, a video game startup in Scottsdale, Ariz., said that he hopes that the flight to safety means that companies like his own will fare better as they try to raise money. The Radar Group, which makes games that can be tied to movies, plans to raise venture capital this summer. Perkins said that he isn't concerned because video games are a recession-proof category. The $30 billion industry's business cycle is more dependent on when new game consoles are announced, not whether consumers are being hit with a recession. And gamers more often than not will opt for in-home entertainment rather than going out or traveling during a recession.

Christian Rees, president of Sipcall, a mobile Internet voice-calling startup in Menlo Park, Calif., said his company has just started looking for money. Rees said that he hasn't seen any impact just yet from the credit crunch as he visits venture capitalists.

"It might impact the venture investors," he said. "We're a consumer-focused company and we save them money. If you're an enterprise company counting on big companies to spend money on your product, then that might be more difficult."

Dean Takahashi is the lead writer for digital media at VentureBeat.com.