2010 VC Funding Outlook for Startups – Prepare for Winter (Part 3/3)

Posted on Oct 2, 2009 | 22 comments


stormIn the first post in this three part series I described why I believe the VC market froze between September 2008 – April 2009.  In the second post I argued that as of September 2009 the pace of VC investments has increased rapidly (at least for software / Internet investments – the only sector on which I’m competent to comment), but only for those remaining VCs who have new enough funds and aren’t plagued by “the triage problem.”  This is a direct result of innovation around the iPhone / mobile computing, Facebook / Social Networks and Twitter (as distinct from Social Networks).  It is also a result of pent-up demand.

In the following post I argue that this increased pace may be temporary.  I obviously don’t have a crystal ball so the economy could fare better than my gut, but here’s why I’m cautious for some time in 2010 or early 2011:

Why is the future still so unpredictable?

1. Consumer spending is 70% of the economy and will continue to be stretched – We can look all we want at tech innovation, VC funding cycles and hot M&A deals, but ultimately growth and therefore investment must be underpinned by revenue.  This is tied to having consumers who feel confident enough to spend.  It affects even B2B companies because ultimately most must sell to companies who sell to consumers and if they suffer they cut back on suppliers.

LCD_Flat_Screen_TV

Consumer spending is where I’m dubious.  I believe that consumer spending over the past 15 years has been fueled by a great run up in the equity value of property that gave consumers what economists call “the wealth effect” and even though the Wikipedia cites some economists who believe it’s only theory – I suggest you read this excellent piece on the Wealth Effect in the Economist – it conforms to my views.

So we loaded up on flat screen TVs, multiple generations of iPods and trips to Hawaii.  We spent our future since the equity was artificial.

So why the ’09 bounce?

When the market run started in March people were relieved that “the world wasn’t ending” so they started spending again.  See point 2 below.  Unemployment coupled with a stock market drop will stop this spending cold IMHO.  I’m not a doomsday guy, but just believe that we won’t see a V shaped recovery, which could make VC funding more difficult for tech start-ups (don’t shoot the messenger!).

2. Unemployment continues to rise – Unemployment as of September 2009 is 9.7% but the truer number of underemployed is a whopping 16.8%! That’s around 1 out of 7 working-age Americans.  To understand this in great detail see this very important blog post by Henry Blodget on the unemployment rate in the US and its impact on the recovery.

3. If these factors impact earnings the stock market may be headed South – If unemployment rises housing prices won’t.  Consumer spending will decrease.  This will likely cause the stock market to contract.  When this happens it takes our 401k’s with it.  The cycle becomes self fulfilling.  Eventually it becomes self healing, but I don’t believe consistent growth will happen too quickly.  That said, the IMF (international monetary fund) is more bullish.  The IMF just raised its global growth forecast from 2.5% to 3.1%.  I wonder, though, how much of that is emerging market and how much of the industrialized nation growth is due to stimulus money, which in turn either dries up or forced inflation?

stock market correction4. If a stock market correction is severe expect a return to the Dog Days of VC is inevitable –   If you read my post on why the VC market dried up in the first place you’ll see that I believe there is a strong (but not 100%) correlation between investor sentiment in the public market performance and the willingness of VC’s to investment money at a rapid pace.  Bad stock markets mean less IPO’s and lower prices for M&A.  This has a tangible impact on the valuation of start-ups and the pace of investment.  If the stock market holds then the pace of VC may hold steady.

5. Don’t forget our industry is still contracting & is threatened by regulation – But it’s worse than just the correlation with public markets and the lack of confidence this cause in some.  The VC constipation is coupled with structural changes in our industry.  Want to know how bad it is to raise money as a VC right now?  Check out this interesting piece on PEHub talking about how Stanford is discreetly looking to sell it’s asset portfolio!  If Stanford has to cut back on VC investing, you can imagine how bad it is getting.  And not only are the total numbers of VC’s decreasing and the amount of funding  in the VC industry as a whole is decreasing but the industry is also threatened by regulation.  I’m not saying regulation will happen, but if it does it will only pile at the wrong time.

My personal views? I believe that innovation will be part of what drives us out of the recession / long-recovery eventually.  I believe that “necessity is the mother of all invention” and that bad times will cause great people to rise to the occasion.  I believe that investments now will lead to leaders in 5 years from now.  So I believe that now is the perfect time to build a company and the perfect time for early-stage investors to bet on innovation. If you’re a startup, in bad times there is less over-funding of your competitors and therefore less pressure to give everything away for free.  You have less wage pressure and less staff turnover.

But I believe I’ll be in the minority of wanting to invest in down markets.  So if I am unnecessarily concerned in this blog post (great!) then the world will be fine for fund raising.  But if I were your friend or adviser I’d remind you, “hope for the best, plan for the worst.”

My advice: if you’re raising a $750,000 round and you have demand for $1.2 million – take it.  If you’re raising $2 million and can close on $3 million – don’t optimize to minimize short-term dilution, optimize for contingencies in case the market gets worse.

Please do not read that I think an early-stage company with limited product and only beta customers should go straight for a $5 million fund raising.  My advice in my post Should You Even Raise VC still holds.  I believe that over funding can be as destructive as under funding.

But I also believe that squirrels that save for a rainy day live when the winter is unexpectedly long.

p.s. I hope that the above factors don’t come to fruition.  I hope that my assessment of the markets is unnecessarily fearful.  My good friend Jeff Cohn sometimes jokingly says that he things being a bear is antithetical to being a VC.  I disagree.  It’s not my job to be a cheerleader.  It’s my job to invest wisely in entrepreneurs who are capital efficient, who innovate in ways that pay off economically in good markets or bad and who plan for worst-case scenarios.

  • http://twitter.com/davidsmuts David Smuts

    I wish I could be as otpimistic about the economy. Unless we seriously (as a nation and a community) begin to foster an innovation culture we risk relying solely on the Government and Wall Street to turn the economy around by printing new debt. Governments now says they can't sustain this level of debt (risk of currency collapse is far worse than risk of continued recession). In which case, if Wall Street isn't getting Government debt to fund itself what recourse is there? Again, only recourse in my view is to innovate (macro economics for you).

  • http://twitter.com/davidsmuts David Smuts

    I wish I could be as otpimistic about the economy. Unless we seriously (as a nation and a community) begin to foster an innovation culture we risk relying solely on the Government and Wall Street to turn the economy around by printing new debt. Governments now says they can't sustain this level of debt (risk of currency collapse is far worse than risk of continued recession). In which case, if Wall Street isn't getting Government debt to fund itself what recourse is there? Again, only recourse in my view is to innovate (macro economics for you).

  • http://lmframework.com/blog/about David Semeria

    Mark, I know this is a tough one to generalize, but on average how many year's worth of capital (runway) do your early stage investments raise, and should the current blip have an impact on this?

  • http://www.twitter.com/biggiesu Mike Su

    Good point regarding going for more money when you can. Reminded me of the story of PayPal's Series C, where they raised $100mm, more than any of them had planned to raise, but Thiel insisted, and closed the round in 3 weeks. The night before, according to the PayPal Wars book by Eric Jackson, Peter insisted everyone work the phones to ensure all the money came through. The day after the round closed, the NASDAQ began an 18 month slide. And of course a year later came 9/11. Had they not done that, they likely would not be in business anymore. Of course in today's world you might want to lop a zero off the end, but the point still stands. Well, unless you're twitter :)

  • guyfriedman

    Great post summarizing how the macro-economic climate will effect the VC community. This may be a bit too theoretical, but the “housing wealth effect” is much stronger than the “stock market wealth effect,” see this paper: http://bit.ly/1mupIT. Robert Shiller is a co-author, so it has to be right =-).

    Thanks again for all of your great posts.

  • http://lmframework.com/blog/about David Semeria

    Mark, I know this is a tough one to generalize, but on average how many year's worth of capital (runway) do your early stage investments raise, and should the current blip have an impact on this?

  • http://www.twitter.com/biggiesu Mike Su

    Good point regarding going for more money when you can. Reminded me of the story of PayPal's Series C, where they raised $100mm, more than any of them had planned to raise, but Thiel insisted, and closed the round in 3 weeks. The night before, according to the PayPal Wars book by Eric Jackson, Peter insisted everyone work the phones to ensure all the money came through. The day after the round closed, the NASDAQ began an 18 month slide. And of course a year later came 9/11. Had they not done that, they likely would not be in business anymore. Of course in today's world you might want to lop a zero off the end, but the point still stands. Well, unless you're twitter :)

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  • http://www.sceneclips.com John Dugan

    With rising unemployment and a shift in consumer spending habits, I think that the big opportunity in ecommerce lies in social shopping. If I can visit Amazon and see not only “people who purchased this item also purchased this”, but “Facebook friends and Twitter followers who purchased this item also purchased this” and strike up a conversation with them about the product(s) that would create a much larger value proposition in my view.

    I completely agree with your broad assessment on the economy. Thanks for the great links as well.

  • http://www.sceneclips.com John Dugan

    With rising unemployment and a shift in consumer spending habits, I think that the big opportunity in ecommerce lies in social shopping. If I can visit Amazon and see not only “people who purchased this item also purchased this”, but “Facebook friends and Twitter followers who purchased this item also purchased this” and strike up a conversation with them about the product(s) that would create a much larger value proposition in my view.

    I completely agree with your broad assessment on the economy. Thanks for the great links as well.

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  • http://bothsidesofthetable.com msuster

    David, the golden rule that VCs are looking for these days is 18 months cash. 12 months means you'll be raising money again in 6 months and 24 months means you have too much cash that you're more likely to spend too quickly!

  • http://bothsidesofthetable.com msuster

    Thanks, John. Yes, it seems that social shopping has potential but thus far hasn't seemed to live up to its hype. It seems that it should work in theory. But I don't think ThisNext, for example, have really killed it.

  • http://lmframework.com/blog/about David Semeria

    Thanks Mark

  • http://bothsidesofthetable.com msuster

    David, the golden rule that VCs are looking for these days is 18 months cash. 12 months means you'll be raising money again in 6 months and 24 months means you have too much cash that you're more likely to spend too quickly!

  • http://bothsidesofthetable.com msuster

    David, the golden rule that VCs are looking for these days is 18 months cash. 12 months means you'll be raising money again in 6 months and 24 months means you have too much cash that you're more likely to spend too quickly!

  • http://bothsidesofthetable.com msuster

    Thanks, John. Yes, it seems that social shopping has potential but thus far hasn't seemed to live up to its hype. It seems that it should work in theory. But I don't think ThisNext, for example, have really killed it.

  • http://bothsidesofthetable.com msuster

    Thanks, John. Yes, it seems that social shopping has potential but thus far hasn't seemed to live up to its hype. It seems that it should work in theory. But I don't think ThisNext, for example, have really killed it.

  • http://lmframework.com/blog/about David Semeria

    Thanks Mark

  • http://lmframework.com/blog/about David Semeria

    Thanks Mark

  • scrivens

    Yeah, still relevant. The UK is in a pretty terrible shape for VC fundraising. But the Europeans are moving in and snapping up some investment bargains. It's a shame to see the Anglo-Saxon model under the cosh..

  • http://twitter.com/mikeyavo Michael Yavonditte

    Sage advice. It's really hard to be optimistic and you are right that your job is not to be a cheerleader. Unfortunately, I predicted the first housing crisis in 2006. I wasn't smart enough to avoid buying a house at that time. In fact, I bought two house between 2006 and 2007, both of which are slightly under water today.

    The economy is still very distressed. It's hard to know what will happen. Any founder/CEO out there should plan for the worst, especially if they haven't reached product market fit by now. Spend money wisely. Common sense stuff.

    If you are doing really well right now then my sense is that you will continue to do well sans a full market crash.

  • dshen

    So accurate – how can any kind of recovery be happening when so many people are unemployed? The cheerleaders in our government should be ashamed to keep throwing all the positive smoke at us.

    Startups need to last as long as possible in today's climate – you won't be able to raise another round if your metrics suck; consumers aren't as willing to part with their cash so making money is harder; companies are preparing for consumers not spending so they pull back and b2b startups also get affected. Only possible solution is to last as long as possible – plan for 2-3 years at least.

  • ElReyalto

    As a startup veteran who was unemployed for awhile until giving up to start my own consulting biz, I agree that the jobs issue is critical to all of this. I've also seen first-hand overfunding in action during the .com insanity and agree it'scan be even more destructive than under-funding. The problem is that a lot of companies are hoarding cash and not reinvesting it back into new hires. Eventually, this is going to turn into a vicious circle as employees are being stretched beyond belief right now because “times are tough.”

    My fear is that when conditions do improve a bit that we will see one of the largest shifts of job movement ever, which will decimate companies that hoarded their cash. The startup world is a bit more used to this given employee tenures tending to be a bit shorter but even they are in for a rude awakening soon.