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What the financial crisis means for entrepreneurs. Part 1: The Problem

The 2008 financial crisis had, at first, relatively mild impact on entrepreneurs.  Ground zero for the crisis was the credit markets, but thankfully, start-ups seldom use credit.  The economy began to slow but had substantial momentum through the end of 2008.  The venture funds that fund start-ups had capital commitments that have been honored in nearly all cases.  The volatile, risky world of venture was, ironically, a calm eye in the heart of the storm.

Nine months on, however, the picture has changed dramatically.

• Many start-ups saw sharp drops in demand in the first quarter of 2009, continuing in the second quarter.  Consumers stopped making postponable purchases.  Housing, autos, and luxury good purchases dropped by 30%-70%.  Businesses supplying these sector have cut production and de-stocked.   Ad spending declined and shifted to forms of advertising that are closely linked to transactions.  In export driven economies (Japan, Germany, Korea, Russia) and the UK the problem is much worse than in the US.  While demand seems to be bottoming and de-stocking is largely over, few expect a rapid recovery.  So start-ups, which typically have concentrated customer bases, saw big parts of their 2008 business disappear.  Any company that is showing substantial growth in 2009 (30%+) over 2008 is doing very well. Many companies need to raise more money (to offset cash flow shortfall) with reduced operating performance to show.
• Exits have gotten even tougher.  The 2008 IPO drought continues, with just a few tech IPOs occurring, and these for companies that have very strong operating metrics (revenue >$100m, many quarters of profitability), and at valuations reflecting the 40% haircut that the equity markets have taken.  M&A exits continue, but they are fewer, standards for scale and profitability have risen, and the buyers are well aware that it is their market.  The old saying that “two bidders is more than twice as good as one bidder” is doubly true now.
• This depresses returns for entrepreneurs and VCs alike.  Net net, a company needs to 1-2 years longer to grow its revenues to the point at which it has critical mass for an exit, may need to raise more money to get there, and ultimately receives a lower valuation.
• The market for follow-on financings (B, C, etc rounds) is like the housing market in California: no one sells who can possibly avoid it, and those who must sell are getting mauled.  Venture funds are conserving capital for existing portfolio companies, so there is little appetite for new investments.  This limited appetite is well satisfied by decent companies that must attract a new investor, because existing investors are tapped out; in these transactions new investors take most of the value.  So most rounds are inside, and companies have very limited ability to add to the capital at the table.
• The venture industry badly needs a way to polish its halo.  The luster from the 1990s is gone:  most venture funds have not made a decent return for investors in ten years (since the 1998 vintage year).  The IT sector is said to be “maturing”.  Biotech holds huge promise in theory but continues to frustrate.  Clean Tech sparked a lot of excitement and raised a lot of money in the last five years, but so far has failed to deliver.  Clean Tech projects tend to be very capital intensive; the freeze-up of the commercial credit markets has put at risk many start-ups that count on tapping those markets when their technologies are ready to scale up.
• The inflow of new commitments to venture funds has dropped in 2009, by nearly half, and there is little prospect that it will bounce back soon.  The institutional investors that fund the VC industry are severely stressed:  their portfolios have shrunk by 1/3 in many cases, and their private equity portfolios have liquidity problems as exits have slowed dramatically but capital calls continue.  And they are quite conscious that the VC industry is inherently risky, has not delivered for a decade, and has term prospects depressed by the exit drought.
• So it’s not surprising that many VCs think that the venture industry is at the start of a shake-out that will be much more severe than in 2001-2004.  The large number of funds raised in 1999-2000 are at or near the end of their planned lives.  They can be extended for a couple of years, but available capital is very limited, and managers will need to make some very tough decisions about portfolio companies.  Many “big-name” funds are hitting headwinds in fund-raising:  partners that previously raised “exclusive” funds with a few phone calls are now seen in hotel lobbies in the Middle East.  Funds that raised $800-$1,000 million last cycle now have $400 million on the cover.  Several well-known funds (Sevin-Rosen, Mobius) have decided not to raise again, and more will follow.  Very likely the amount of capital available and the number of VCs deploying it will be much smaller in five years, although who the survivors will be is hotly debated (I’ll spare you the usual self-serving rhetoric here).
  

It’s an ugly picture.  And it won’t improve soon.  There will be less money available, fewer places to go in search of it, and increased uncertainty as the venture industry restructures.

What steps can entrepreneurs take to survive and prosper?  I’ll try to answer in my next post.