Now for the bad news: less investment money for startups

I wrote yesterday that using the economy as an excuse for failure doesn’t stack up. In that post I noted that the economic downturn may actually offer new opportunities, such as increased users as people go out less and through to advertising opportunities as companies spend more to minimize the effects of a slump in consumption. They’re all positives, and they’re all true, but that doesn’t mean that there isn’t bad news as well.

The biggest hit in the web 2.0 space is going to be for unfunded startups who need money, and existing startups who need more money to survive.

The money is going to run out.

Not entirely, it never does. But the buoyant days of venture capital funding for all, typical of the second great web boom are about to end.

The cash crisis

Fundamental to the still developing economic situation today is a crisis in cash, ignoring the problems that have led to this point. Banks have either completely stopped lending, or have stopped lending to other banks, restricting the flow of debt based finance (banks lend money from other banks for lending purposed). Barack Obama described it in the last Presidential Debate well:

Right now, the credit markets are frozen up and what that means, as a practical matter, is that small businesses and some large businesses just can’t get loans. If they can’t get a loan, that means that they can’t make payroll. If they can’t make payroll, then they may end up having to shut their doors and lay people off.

Debt based finance isn’t a typical situation in most startups, although it’s not unheard of. But that contraction in finance does have flow on affects. The money coming into venture capital funds has to come from somewhere, and typically that’s been a combination of direct investment, banks and funds. Each take a hit:

• Direct investment presumes availability of funds from direct investors. While some of that includes the VC’s themselves, it also includes “sophisticated” investors who have surplus cash and are looking for high returns. These investors will have exposure to the broader market (in multiple ways) so may simply end up with less cash at hand to invest, or become more risk adverse, choosing to hold onto their cash or invest it in safer investments
• Funds: funds management arms are taking a huge hit at the moment, from reduced share prices, to debt restrictions (debt can often be a financing vehicle in investment arms). One example: pension funds are said to have dropped 20%, or 1 trillion dollars in the US in the last 12 months. There is now less money under management, and what is left will be looking for safe havens, not high risk investments. There will still be money for VC’s here, but there will be a reduction.
• Banks: finance can and is regularly used as an instrument by VC’s, and some banks are direct investors themselves (Lehman Brothers was a big investor for example). If banks are struggling to fund their own liabilities, the risk component becomes more conservative.

The common factor is that we don’t know how much this is going to hurt venture capital in the web industry, we just know that it will. The scenarios range from a small impact: many venture capital firms are already sitting on funds, and may have enough to ride out the worst of it until things pick up; to serious impact: VC’s cannot raise new rounds at all, or in such volume that the funding market for web based companies completely dries up. If I was to bet, I’d say it’s likely going to be some where in the middle of the two.

Profit or die

The contraction in venture capital for existing companies will present one simple outcome: the days of not having a business plan and not making a profit will soon be over, and the longer the economic crisis continues, the more so this will be. Some companies will have cash reserves and will be able to ride out the crisis at least for the short term, but those on the edge now are in big trouble. The only way to survive an economic downturn is profitability, because profit pays the wages, and gives any business a future.

Better startups?

The scarcity in venture capital will fundamentally change what gets funded, if anyone gets funding at all. Nat Torkington at O’Reilly thinks that lack of funding will be a good thing for innovation:

this recession will be good for innovation because recessions generally are. During boom times, companies direct development and occupy great talent with at best evolutionary improvements over the state of the art. Companies are great chasers of new things, but aren’t great at making new things. A recession means technologists cease to be paid vast amounts to duplicate the work of others. The Great Tech Bust of Ought Two gave us 37Signals, Flickr, and del.icio.us and there’s a strong argument to be made that many companies spent the next six years chasing what they created.

Certainly he has a point: in a funding scarce environment, it will be startups who stand out from the crowd who get funded, and most definitely being different and innovative will be an important factor.

Conclusion (or simply the end perhaps?)

I’m a little torn on this. I hate to think that venture capital will be harder to come by when for anyone outside the United States (and particularly the Valley) it already is. There will be companies that die along the way that may have made it with another round, and good people will suffer.

And yet, the excess was always going to come to an end eventually. The second web boom wasn’t as overboard as the first one: we’ve not seen the ridiculous rounds and valuations that led to the first crash. And yet the problem isn’t one of too much cash for companies this time, it was one of too many companies getting cash without either a proven business model, or as is the case with Twitter and some others, any business model at all. That many startups will fail is not the fault of the economic crisis, even if it may bring forward their deaths, it is a failure of startups to focus on business fundamentals, such as making money. Those with solid businesses, making a profit or close there to it, will ride this out, and what’s left standing may in the long term be beneficial to us all.