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Think Big. Move Fast.

It is difficult for startup companies to raise venture capital at the best of times. A venture capitalist might get emailed 5-10 pitches from startups each day. Over the course of a year that adds up to 2,500-5,000 pitches. Of those pitches, that venture capitalist might fund one or two companies. Not great odds for a startup. Granted, some of the other startups may raise funding from other venture capital firms, but even so, it’s a chancy proposition.

Recently, startups have been facing an even more difficult environment for raising capital. There are three factors that are contributing to this. Some of these factors will change in the short term, but others will likely continue to be a factor for a while. From longest to shortest then:

Angel financing has dried up. Often, when a company is too early to raise institutional venture capital it will raise money from angel investors – wealthy individuals. According to the Center for Venture Research, $26B was invested by angels in 2007, a marked increase compared to $15.7B in 2002. The precipitous drop in stock markets and housing markets since the beginning of the year has made many angel investors nervous about making new investments in risky and illiquid startups. Many angel investors will likely sit on the sidelines until we see a rise in stock markets and in consumer confidence. While the companies who raise angel financing would not likely have raised from venture capital firms anyway, a slowing down of angel financing will mean that less companies are ready for institutional venture capital in the next few years.

A slowing economy has reduced near term revenue growth expectations.
We are in a recession. While for many startups, the micro factors (e.g. Did we hire our second sales person in Q1 or Q3? Was our VC able to introduce us to BigCo for a distribution deal?) trump the macro factors, startups still operate in the same economy as everyone else. With consumers and enterprises alike watching their spending closely, even the most promising startups are likely to see slower growth than they might have projected a year ago. Slower revenue growth usually translates into a longer period before the company gets to profitability, and hence more capital required. Strong companies will still get funded, but each financing may be a little larger than in the recent past to give the companies the additional runway to get to profitability. As a result, there may be a slight reduction in the overall number of financings (given that the pool of available capital is largely the same) and some marginal companies will not be able to raise capital. Since early stage venture capital firms by definition take a long term view, this impact is likely small, but will persist until investor expectations for consumer and enterprise spending improve. As we get additional data on the likely length and depth of this recession through 2009, this effect will likely disappear.

Venture Capitalists are focusing on their portfolio companies. The slowing economy affects not just companies raising finance, but also companies that have already been funded. VCs are currently fully engaged with their current portfolio, helping them to prepare for a tough 2009. Many entrepreneurs are first time CEOs, and some were not even in the workforce during the last recession. They are turning to their VC investors to help them think through what actions their companies need to take to adjust; cost reductions, changes in strategic direction, or otherwise. This takes time. Time spent by VCs with portfolio companies is time not spent looking at new potential investments. As a result, companies currently seeking financing may not get the same level of attention that they might have received a few months ago. The good news for startups is that this is a short term effect. 2009 planning should be completed within the next few weeks, and certainly after the holidays, venture capitalists time will once again free up to look at new deals.

Better time ahead. Although startups seeking financing right now may have a tough time, as these factors fade away they should see a relative improvement in the very short term. As the market will only improve, startups looking to raise new financing should try to defer for as long as possible. This may require cutting costs to extend the cash runway, reducing the scope of projects, prioritizing revenue over new features or looking to existing investors to provide a bridge loan. But do not lose hope! Promising companies will continue to get funded, with the pace returning to close to normal by part way through 2009.

  • http://techlang.com/ TechLang

    Thanks for words by a VC, many great companies grow in the recession, true entrepreneurship still live

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  • http://www.perkler.com Dan Bisa

    Yeah we are battening down the hatches here at perkler.com. Mind you it helps that we have a small headcount and were already running on the smell of an oily rag. What the crisis has done for us is to even further highlight the need to ration our funds into the most relevant areas.

    Prior to the crunch we had established a roadmap to revenue and ultimately profitability. But now the most popular question around the office is “how do we shorten the revenue gap”? This is going to mean diverting scarce resources away from additional tools and improvements for users…towards additional fee generating output for clients.

    One idea is to beef up our data mining capability and package the results up into various products that we know prospective clients will like.

    So for us its a see-saw with user experience on one end and client revenue on the other. In a perfect world we would be funded and hit both sides with vigour…but now we are getting the user product to a certain stage of completion that we think is compelling…and releasing the hounds onto revenue generation.

  • http://www.beyondmotherhood.com Shannon Davis

    Great post. Thanks for giving us budding entrepreneurs hope!

  • a

    And the Bubble 2.0 will happen next year.

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  • http://www.tradavo.com Bobby Martyna

    Can’t help but thinking that this isn’t a bad development. As with the economy at large, individuals and companies have been living and leveraging on the promises of continued growth — in housing prices, GDP growth, IT spending, etc.

    That syndrome helped to create the VC market in the first place. Prior to the 60s, most companies were started in the right sequence — start small with a small investment, build to profitable model, then grow.

    The emergence of venture capital reversed that. While the ‘reverse’ model does work for a very small minority of companies in very special circumstances, I believe far too many startup companies have been founded with that model as a foundation.

  • http://www.valleychai.com spandana

    thanks for a great post.

    any insights into capital inflow into VC funds? assuming its weakening, how is the outlook for 2010 and beyond?

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  • http://www.wholesaleinvestor.com.au Steve

    We launched our magazine because of this very issue. In Australia, it is hard for private companies to get any sort of visibility or promotion for their capital raising deals.

    The response from the industry and companies alike has been positive. We connect them via our magazine and website.

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