In 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.
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?
4. 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.