More articles predicting doom for startups

I feel like the grim reaper here… really I’m not throwing myself out a window.

So why am I posting these? it is important for entrepreneurs to NOT bury their heads in the sand.

I would also take a moment to point out that the majority of this news is coming from Silicon Valley – by far the easiest place to raise capital. If you are not based in Silicon Valley the news is probably worse.

The important thing is not to panic and plot a course of action TODAY – What should you do – you can start by reading Ron Conway’s letter to the companies he has invested in. I’m following this advice – and you should too.

Sorry, Startups: Party’s Over – Silicon Alley Insider

Sequoia Capital, best known during this bubble as the guys who backed YouTube, gathered some of their startups Tuesday for an emergency meeting. “The attendees were greeted by a cute image of a Grave Stone, with a message: R.I.P.: Good Times,” Om Malik reports.

Super Angel Ron Conway To Would-Be Startups: Don’t Quit Your Day Jobs – Silicon Alley Insider

Different story, says Ron Conway, who is perhaps the most famous angel investor in tech these days. Ron is best known for making very early and very lucrative bets on Google and PayPal, but he’s also known as one of the most adventurous angels of Bubble 2.0, and has invested in 130 companies since 2005. We asked him for his advice to would-be-startups last night, and he wasn’t nearly as encouraging:

“I would tell (entrepreneurs) to keep their day job until they got one year of funding, and if they couldn’t get that, then they’re not meant to start that company right now…. My advice to (start ups that don’t have a year’s worth of money in the bank) would be to raise money by reducing your own spending. If you can’t raise more money, you have to cut costs. And that’s what I’m harping on to my companies.”

Fred Wilson: My Thoughts On ‘Startup Depression’– Silicon Alley Insider

All startups are going to have to batten down the hatches, get leaner, and work to get profitable, but the venture backed startups are going to get more time to get through this process than those that are not venture backed. Here’s why.

Venture capital firms are largely flush with capital from sources that are mostly rock solid. If you look back at the last market downturn, most venture capital firms did not lose their funding sources (we did at Flatiron but that’s a different story). If you are an entrepreneur that is backed by a well established venture capital firm, or ideally a syndicate of well established venture capital firms, then you have investors who have the capacity to support your business for at least 3-5 years (for most companies).

More bad news for Startups.

Today Stacey Higginbotham of GigaOm wrote an article about the deterioration in VC and Angel funding in 2008. While the picture she paints is far from rosy – I think she understates the issue in some ways. With others calling for a startup depression I think we need to be realistic.

That’s not great news, and it’s also likely that overall investment for the year will drop for the first time since 2003, Tracy Lefteroff, a managing partner at PricewaterhouseCoopers LLP, told Bloomberg this morning. Last year, venture firms put $30.69 billion into startups. During the first half of 2008, venture firms invested $14.89 billion, climbing to $20.6 billion if we add in the preliminary third-quarter numbers. It’s unlikely that venture firms are going to put more than $10.09 billion in portfolio companies between this month and Christmas. The last time that happened was in 2000.

Mark Heesen, president of the National Venture Capital Association, says that skittish investors are helping create a poor exit environment for VC-backed companies. So far this year there have been just six initial public offerings and 199 acquisitions through the third quarter — 72 fewer than this time last year.

“We have not seen a reduction in the number of first-time financings in the first two quarters, and we may see some lag on those deals decreasing,” Heesen says. “I believe it will be the fourth quarter that we’ll see the impact that the lack of an exit market has. I am certainly hearing anecdotally that venture capitalists are doing fewer deals.”

Quite honestly that isn’t the scary part. What is scary is that while VCs are doing fewer deals – and that means more deals that involve bigger investments and bigger ownership stakes – they will be demanding that the companies they invest in have cleared “seed stage”. In other words that they have revenues (and preferably profits). Why is that scary?

Venture investors aren’t the only sources of startup capital that are feeling cautious. Data out today from the Center for Venture Research at the University of New Hampshire shows that while in the first half of this year angel investments were up slightly, the number of deals getting funding was down. Total investments in the first and second quarters of 2008 were $12.4 billion, an increase of 4.2 percent over the same period last year. A total of 23,100 entrepreneurial ventures received angel funding in the first half of 2008, a slight decrease of 3.8 percent from the same period last year.

This combination results in a significant problem for the entrepreneur. The bridge – seed stage funding – to move a product or service to viability is gone. We will all have to bootstrap (self fund) to profitability.

Now for the really bad news. Even those with significant capital of their own available to bootstrap will need to seriously ask themselves if they are willing to take that risk right now. Those factors – when viewed a cycle – can lead to exactly the kind of startup depression that the country can not afford right now.

Turns out Angel Investors do not make much on investments…

From AZCentral’s Innovator’s Circle blog by Andrew Johnson:

Fledgling companies often turn to “angel” investors when they’re trying to fund start-up costs.

The term refers to individuals who invest small amounts of money – typically under $2 million – in early-stage firms. They hope to get a return on their investments once the firms start generating a profit.

Although such investors are more willing to funnel money to companies that are dealing with unproven technology or have a significant customer base, many still require companies to have a management team and potential for commercial success before they provide funding.

Thus, many early-stage entrepreneurs complain that they can’t get these early-stage investors to provide capital.

A study released Thursday by the U.S. Small Business Administration’s Office of Advocacy may provide a reason why some angels are apprehensive to take a risk on these firms.

The study, “The Importance of Angel Investing in Financing the Growth of Entrepreneurial Ventures,” says the majority of such investors do not experience positive returns after placing their money in the firms.

The reason, according to researchers, is that the most profitable investments typically come from companies that go public. However, “only a small portion of angel-backed companies go public,” the study says.

The study noted the difficulty in pinpointing exact returns for angels because of challenges in defining a truly representative sample of such investors.

However, the study cited other research conducted in 2007 in which 539 angel investors from 86 associations were surveyed.

Combined, the 86 groups had made 3,097 investments, from which they experienced 1,137 “exits.” An exit refers to when a company is bought by or merged with another firm or goes public. Typically such an events are when investors see the biggest return.

The average investment made by the sample in that study turned a profit of $295,000 on an investment of $191,000 in 3.52 years.

However, the median investment for this group was $50,000, and “that returned $40,000 or 80 cents on the dollar,” the study said.

The study included other information that differs from common perceptions researchers and start-up companies have about angel investing.

The market for such investments is considerably “smaller than is generally believed,” the study said. “Few companies are appropriate for angel financing, a fact that limits demand for this source of financing.”

Also, a big portion of angel investors fund their investments with debt or equity, contrary to the belief that they not as interested in taking an ownership stake in the firms they provide funding to.

[From Few ‘angel’ investors get positive returns, study says]

Given the state of the economy and markets – this is not good press for those of us trying to raise seed funding.

As it turns out the recovery from every financial downturn has been led by small businesses. With micro businesses currently representing 95% of all U.S. firms we need to be aware that cutting off capital to “high risk” startups will deepen the current crisis… not improve it. The economy can only recover when we start developing high pay, high value jobs in the U.S. – more jobs at WalMart will not do it.

Why is this so important. Home prices are an issue because the cost of housing has increased while wages have not. Only when those numbers are brought back into balance can any real recovery take place. There are two ways to do that:

  1. Reduce the cost of housing
  2. Increase wages

The problem with the first option is that is requires tens of thousands of (more) foreclosures to bring things back into balance. Investing in small businesses is the best path to creating high wage/high value jobs which will support home prices at (something reasonably near) current values.

If all the capital evaporates from the SMB sector – specifically if individual investors (i.e., Angels) close their wallets the SMB sector will crash.

Net/net – watch the small business sector – if we start to see that sector crash we know this will be a long protracted downturn.