The vocabulary of this month's financial news has been dismal, with words like slumping, collapsing, and failure dominating the media lexicon. While the tumult has prompted credit scarcity, layoffs, and write-downs for many companies, the market for tech startups has remained a small and viable haven.
It may seem sanguine to use the word "haven," since no corner of the economy is impervious to larger trends. But because venture capitalists work on long fundraising timetables and deal in liquid money, faltering banks and crises of credit don't effect VC funds as acutely as they do other institutions. That means startups can continue be free to innovate and grow, with money in the bank.
According to Eric Litman, a serial entrepreneur and former head of the incubator WashingtonVC, negative economic conditions trickle down to venture capitalists slowly, leaving them somewhat resistant to macroeconomic trends. "Much like entrepreneurs, VCs typically go on fundraising road shows lasting anywhere between four months and a year to acquire all of the capital they'll need for the five- to seven-year life of the fund," he says. Once that cash is collected, they usually spend it according to plan, regardless of what's happening in the markets.
That squirrel-like mentality continues to be evident among Silicon Valley startups, even as each week brings more woeful economic news. David Rusenko, co-founder of the website-creation tool Weebly.com, says that venture capitalists will definitely revise their methodology in light of the bear market, but that the flow of money isn't being affected. "We continue to get offers every week for more funding," he says, "but we're turning them down since we've become profitable."
Venture funds rely on liquid money to capitalize companies, not credit. Often, they round up cash from well-capitalized institutions like hedge funds or universities looking for risky investments. Market corrections may even help venture funds, as they did in 2006-7; when interest rates are kept high to curb inflation, heavyweight investors may look to venture funds as a place for their alternative assets, instead of engaging in buyouts or other private equity activities.
If they need even more money, venture partners usually take on a limited partner, or LP, who makes a legally-binding commitment to bring more capital to the table, regardless of whether their confidence in the fund — or the economy — wavers. The fund, in turn, gives a company of their choice a lump sum up front. And while they may choose not to invest in a company twice, one massive cash infusion is often enough to keep most tech startups sailing, no matter what havoc is being wreaked in the economy.
What makes tech startups so lucky? While it's true that bearish trends can make for great investment opportunities in many markets, small technology companies are particularly deft at taking advantage of a bad economy. As Litman explains, a bear market can cut the costs of starting and running a business, particularly the costs of real estate and salaries.
But he notes that tech startups have especially low startup and operating costs, perhaps because many of their products — like web services or software — are intangible. The Y-Combinator fund, for example, gives its seedlings a total of just $20,000 for a three-month incubation period, often for a company with two or three founders. Try starting almost any other business with that, and you'll see why tech startups remain such attractive investments in lean times.
Faced with a worsening market, venture capitalists will indeed be changing their strategies, however. Since they have to think long-term, they know that this market contraction will hurt their ability to raise funds later. Michael Siebel is a co-founder of Justin.tv, another Y-Combinator company which was later funded by New Enterprise Associates and Alsop Louie Partners. He has watched the current crop of Valley startups make the rounds looking for mid-stage funding.
"When the venture funds know money will be tight, they want either amazingly disruptive ideas, or ideas with sound business fundamentals," he says. "They're becoming more focused, and playing their cards closer to the chest."
Rusenko predicts that for some venture capitalists, the funding focus will shift to later-stage startups who have more proven popularity or more developed business plans. "The earlier ones will still get off the ground," he adds, "but they won't get, say, six million bucks up front. They'll have to slog through the beginning." On a small number of game-changing ideas will get plucked from the early-stage field.
Whether or not they can secure funding, the new crop of tech hopefuls will also have to deal with more reticent advertisers, and consumers less willing to spend money online. In short, the next round of startups won't be the "as much of a glitzy, rockstar process" as it was earlier this year, Rusenko predicts.
But that, he says, isn't necessarily a bad thing. "Companies started during a downturn are the ones that have proven themselves and developed great products," he says. "And ultimately, those are the businesses that sell."