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An entrepreneur asked me recently if I was concerned about the impact the credit crunch will have on venture financing for startups. I responded:

For high quality companies, the short answer is no. The more nuanced answer is that

(i) The credit crunch will impact venture debt (already has) so people can’t count on that to extend their runway, so should raise a bit more than they would have done
(ii) If the economy indeed slips into recession (as a second order effect of the credit crunch), then this will impact sales growth for many startups, whether selling to enterprises or consumers. This will also impact timelines to profitability, and hence amount raised. It will also likely cause some angels and some venture firms (especially corporate venture firms and firms with a shorter time horizon) to become less active investors.

At Lightspeed as we take a long term view towards the companies we invest in. However, we are urging them to be conservative in their revenue projections and hence cash planning (both from amount raised and from cash burn perspective).

GigaOm weighs in on the venture debt issue in particular

Fewer, costlier loans. No way around it, money is getting more expensive. As long as banks are licking their wounded balance sheets, they won’t make loans that carry even a whiff of risk. This could raise borrowing costs and complicate growth for capital-intensive sectors, like telecom.

A more immediate problems lurks in short-term lending such as commercial paper. Interest rates in that part of the market have recently risen from 2 percent to 4.5 percent for riskier companies, according to Businessweek.

Fred Wilson has a similar perspective on the venture capital market:

All startups are going to have to batten down the hatches, get leaner, and work to get profitable, but the venture backed startups are going to get more time to get through this process than those that are not venture backed. Here’s why.

Venture capital firms are largely flush with capital from sources that are mostly rock solid. If you look back at the last market downturn, most venture capital firms did not lose their funding sources (we did at Flatiron but that’s a different story). If you are an entrepreneur that is backed by a well established venture capital firm, or ideally a syndicate of well established venture capital firms, then you have investors who have the capacity to support your business for at least 3-5 years (for most companies).

Venture capital firms will get more conservative and they will urge their portfolio companies to do everything Jason suggests (and more), but they will also be there with additional capital infusions when and if the companies are making good progress toward a growing profitable business.

If you go back and look at the 2000-2003 period (the nuclear winter in startup speak), you’ll see that venture firms continued to support most of their companies that were supportable. The companies that were clearly not working, or were burning too much money to be supportable in a down market, got shut down. But my observation of that time tells me that at least half and possibly as much as two/thirds of all venture backed companies that were funded pre-market bust got additional funding rounds done post bust.

So if you run or work in a startup company that is backed by well established venture capital firms, take a brief sigh of relief and then immediately get working on the “leaner, focused, profitable” mantra and drive toward those goals relentlessly.

If, on the other hand, you are just starting a company, or have angels backing you, or are backed by first time venture firms that are not funded by traditional sources, then I think you’ve got a bigger problem on your hands. It’s not an impossible problem to solve, but you have to start thinking about how you are going to get where you want to go without venture funding.

I say that because in down market cycles, it’s the seed and startup stage investing that dries up first. It happens every time. Seed/startup investing is most profitable early in a venture cycle and late stage investing is most profitable late in a venture cycle. It makes sense if you think of venture capital as a cyclical business and it is very cyclical. Early in a cycle you want to back young companies at bargain prices and enjoy the demand for those companies as the cycle takes hold. Late in a cycle you want to back established companies that need a “last round” to get to breakeven and you can get that at a bargain price compared to what others paid before you. I’ve been in the venture capital business since 1986 (that was a down cycle) and I’ve seen this happen at least three times, probably four times now.

There’s another important reason why seed and startup investing dries up in down cycles. Venture firms don’t need to spend as much time on their existing portfolio companies when things are going well. A rising market hides a lot of problems. But when things go south, they tend to become inwardly focused. I believe we are headed into a period where venture firms will spend more time on their existing portfolio and less time adding new names to it.

Plan appropriately

  • Dean Gebert
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  • http://strategic-space.com Mark Salzwedel

    I certainly understand the fear in private investors and venture capitalists in investing in startups in economic times like these. I think there are strategies for testing the waters and for looking at things a bit differently that might be helpful.

    I started a board game publishing company a little over a year ago. I overestimated revenues and underestimated costs, like most of us entrepreneurs do, and so my angel investors’ money didn’t go quite far enough. I started paying production and overhead expenses with revolving credit. Now sales are starting to build as we’re hiring sales reps, got a big award for one game, and we’re in the midst of a national media campaign. But we are likely to run out of inventory on our existing games and not be able to afford the large first runs of three new games that are already in demand. My credit score is too low now, even though I pay all my bills on time because my balances are too high. The company hasn’t been in business long enough to have its own credit evaluated. My business partners haven’t been involved in the company long enough to risk their credit on the company yet. My current angel investors are tapped out, and I’m trying to repay them at a slower rate than originally promised. All the new angel investors who have contacted us refuse to commit to investing until they know their investment will be returned with interest in 6 months or less! The unsecured credit companies say they have plenty of money to invest but their rates (prime plus 2 or 3 percent) would cripple us.

    I continue to try to sell inexpensive board games in a market that expects high production values, but doesn’t want to pay the $50 it would cost to bring it to them. I continue to seek independent investors. I keep pushing publicity and advertising and promotion opportunities every week. I am negotiating co-publishing arrangements with various corporations. I am working on co-marketing programs with other game publishers. I’ve been contacted by TV producers for a documentary series on new toy inventors that should go into production soon. One of our games won Top Toy 2008 from ToyDirectory.com.

    It just amazes me that that level of potential and a 10% ROI is still not enough for so many investors.

  • http://blog.buyplaywin.com Aziz Grieser

    Hi Jeremy, good response to open this post.

    I didn’t catch whether LightSpeed was pulling back on new investments, but I did get a more general feeling from you that it would be the result of recent financial trends. You also seemed to agree with Fred Wilson and his excerpt from his recent post.

    If LightSpeed and most VC firms are also pulling back on new investments and streamlining their current portfolios, then I predict a big change will come to high tech start-up markets within 5 years: risky innovators will go where the capital is.

    Nanjing Software Park branch of Nanjing New High Technology Industry Development Zone – Nanjing Software Park was established in 1999 and was approved as the software industry base of National Torch Program, the first state-level software industry base. The planned area of Nanjing Software Park is 3.58km2. At present, there are 220 companies and more than 12000 staff working in the park. There are many well-known software companies registered there.

    There are hundreds of Chinese VCs and high tech dev shops wooing companies from the US to setup joint ventures there at the Fourth China Nanjing International Software Products Expo. I know, because one of my team members was wooed there, all expenses paid.

    Now, look to the Middle East with me…

    Qatar Science & Technology Park Unveils Roadmap for Middle East to develop their technology, and help entrepreneurs to launch new technology businesses.

    I am conflicted.

    As an American, I am proud of our universities that are the real reason for the creation of Silicon Valley and American high tech dominance.

    As a start-up CEO and world citizen, I know that the future of my business depends on two things: (1) my securing start-up capital now, at one of the worst times in US financial history, and (2) competing in an international market.

    Based on the above, I think we’re going to feel a major power shift ,that is just really starting now, in about 5 years.

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  • http://strategic-space.com Mark Salzwedel

    Interesting turn of events: We are getting a lot more inquiries in start-up financing. Investors are cashing out of their stocks and trying to recoup losses by investing in startups, which USED TO BE higher risk than the stock market, and potentially have higher growth.