Friday, December 12, 2008

A startup founder's personal view of the impact of the financial crisis on Silicon Valley's startup scene

I left Google about 14 months ago to start my own company. I had long wanted to start a company and thought the economy was about to take a turn for the worst - so it made sense to get out and start something and hopefully raise some money before everything came tumbling down. It took a little bit longer then I thought for the economy to sour, but what I am seeing and hearing from friends starting companies or investing as venture capitalists is worse then I had anticipated now that the economy is officially hurting.

2000-2002: A reminder of the recent past*
For those of you who lived through the bubble and its deflation in 2000-2002 the following timeline unfolded:
  • March 2000: The NASDAQ peaked
  • Mid-to-late 2000 through 2001: Consumer deals cease to get funded. Consumer companies do big rounds of layoffs and some shut down. Investors switch from focusing on consumer startups and started to invest in infrastructure. "The people who made money in the gold rush sold picks and shovels - they weren't miners" was the refrain at the time. In part, this ongoing funding may have been driven by an overhang in the amount of venture capital raised in the good times of the Internet bubble (there were a lot of funds with a lot of money, and they "had to put it somewhere").
  • Mid-to-late 2001 through early 2002: The telecom and infrastructure side of things dried up and funding came to a grinding halt. Telecom and infrastructure companies cease to get funded and do big rounds of layoffs or shut down. There was a period of maybe 6 months were it was very hard to raise money. Things started to loosen up in late 2002 and then picked up in 2003-2004.
*I don't have any data to back this up - the above is all based on my personal experiences as someone working at startups in Silicon Valley at the time.

The gist of it, is that it felt like it took 12-18 months post public markets peak for the startup/venture market to completely freeze up. This "freeze" lasted a short period and then more and more consumer startups were started and funded leading to the current crop of brand name sites (Facebook, Digg, etc.).

2007-?: What is similar
From a timing perspective (relative to public market valuations for technology companies), it looks like things may be following a somewhat similar path.
  • November 2007: The NASDAQ peaked
  • 2007-mid-2008: People kept talking about the coming recession but companies kept getting funded, in some cases for very high valuations (there were a lot of new funds with a lot of money, as well as hedge funds and other non-traditional funding sources wanting to play the venture game).
  • End of 2008: companies are having a tough time raising their next round of financing. Layoffs are hitting multiple startups and a handful are starting to shut down. It feels like every startup on the planet is making the rounds to raise a last minute emergency round so Sand Hill is a busy place right now.
If the timing truly mirrors that of the last bubble deflation, Q1 of 2009 is going to be the bloodbath when many more startups shut down. We will then have a freeze in venture capital lasting 1-2 quarters, and things will pick up again end of 2009 early 2010. The big question is - how similar is this downturn to the last one?

2007-? What is different**
The difference this time around is that we are dealing with is a fundamentally different type of bubble (financial asset/credit bubble vs technology one) deflating, and the impact or ramifications may similarly differ. Most importantly, credit is drying up in parallel to the fact that this recession will be longer and deeper then the previous one. (Now that data has been released, this is a "tell me something I don't know" observation, since the recession officially started in December 2007). This means that just like in 2001-2002:
  1. public markets will be closed to exits by companies even thought they are in a good financial position to go public (e.g. OpenTable, etc.)
  2. valuations will take a hit for a while, so startup entrepreneurs will be able to raise less money at crappier valuations or have to give up more of their companies once people start investing more)
However, the less obvious takeaways are:

(1) Big endowments& pension funds have lost a lot of money in the stock market. Harvard's endowment has lost 25% over the last few months - this is equal to $8 billion or the aggregate size of ALL other university endowments outside of the top 5 or so largest. Endowments have charters which limit the amount of their capital that can go to high risk investments - in other words venture fund and private equity firms. This means that they need to "rebalance" their portfolios and shift money that would normally have gone into venture funds back into public markets.

This will have the following ramifications:
  • Many non-brand name venture funds (e.g. new ones, or lower tier ones) will go out of business. Venture funds don't receive all their money in one big chunk at once. Instead they do "capital calls" to their limited partners (LPs) periodically as they need more money that the LP committed. If the LP does not meet this capital call (i.e. give additional money the commited), then the LP may lose their already existing shares in the venture fund. This means, if a venture fund is relatively young/new, the LP loses little by walking away at this point (since the venture fund will not have invested in many companies yet). The net takeaway of this is the venture fund will not be able to raise the $ it needs, it will not be able to fund more companies, and will need to dissolve.
  • Unexpectedly, some brand name venture funds are being impacted by this same dynamic. I spoke with a friend of mine at a top tier fund yesterday, and he mentioned that even some of the top endowments are rebalancing their portfolios to such an extent that they are trying to sell their shares in the venture funds to other 3rd parties.
The net of point (1) here is - it will be harder to raise money since lower tier funds will go away, decreasing competition for deals and driving down valuations (similarly hedge funds etc. are sharply curtailing their investment in early stage companies).

(2) Traditional venture funds are starting to look at public market deals. I have heard from a number of VCs who usually only invest in private companies that they are taking a look at buying out or investing in public companies. The reason: some EBITDA positive companies, with reasonable EBITDA growth are trading under cash (Warren Buffet must have tears in his eyes). Why invest in a high risk illiquid startup when you can buy a cash flow positive public technology company with a higher probability of achieving a strong return?

(3) If it takes a long time for companies in a VCs portfolio to exit, the VC will have less bandwidth to do new deals. A VC typically can effectively only sit on so many boards at once, so no exits = fewer opportunities to leave a board and move on to the next great thing. In a long recession with few exits, this may have an interesting impact on "venture bandwidth".

The impact I have been seeing amongst friends:
  • About a year ago, coming from Google and assembling a good team more or less meant that you could raise money. I know of two recent startups founded by ex-Googlers who are likely to be put on hold due to an inability to raise money (I am tracking 30 or so startups started by former Googlers, so this is still a small % of total.).
  • I also know of multiple startups of various origins that raised a seed round that have been shutting down as they can not raise a Series A. On the investor side, all the VCs I know seem very crammed these days - they are spending a lot of time either:
(a) helping their existing portfolio companies raise money or
(b) talking to all the various people coming through hoping to raise a last minute round. Increasingly these rounds are at the valuation of the previous round, or are down rounds (i.e. lower then the valuation the entrepreneurs got in the previous round - this often means the entrepreneur will be more or less wiped out equity-wise).

**Again, I have on hard data. This is all random word of mouth I have been hearing. So, it is quite possible this assessment is way off.

I think the overall gist of it is:
2009 will not surprisingly be do or die for many startups in the valley. The ones that raised lots of money early (e.g. Slide, Ning, etc.) will come out on the other side. The ones that are able to raise money in the coming tough year, or who can get to profitability or psuedo-self funding will be extremely well positioned as well. The big question is how long the coming venture capital freeze will last.

At some point the freeze will thaw, the carnage will pass, and silicon valley will rebalance itself. People will always need innovative new products, and VCs will move from cleaning up their portfolios to investing in more new companies again.

(As an aside, I think this is also a good time to be an entrepreneur - it has never been cheaper to start a company. But scaling a company rapidly if it is getting initial traction will require venture capital in most cases. If there is interest I may write a follow on post on the specifics about how these times may benefit those companies that have the cash and wherewithal to survive....)

Anyhow, I just wanted to collect my thoughts on all this and a blog seemed like a reasonable way to do so. Look forward to people's thoughts on how the next year or two will shape up.