How bad is the recession for start-ups?

Portrait shows Florence Thompson with several ...Image via WikipediaIn Madrid today, a smart guy asked me a question: what will the current economic climate mean for the technology start-up ecosystem? The answer is complex but in a nutshell it should create more opportunities for entrepreneurs than fewer.

If you don’t need persuading we are heading for a recession, then skip ahead to the analysis for start-ups

Let’s recap with what is going on: the major developed economies appear to be moving towards recession with an unpleasant combination of inflation, declining growth and rising interest rates all taking a whack at corporate profits. A recession is not a short event, think three years not 12 months during which time interest rates will go parabolic, corporate spending will dry up and p&l’s will go red.

After the worst June for the Dow index since the Depression, stockmarkets are rapidly heading towards bear market territory. We can look forward to several further quarters of poor equity performance.

High oil prices are slowing economic growth and causing spikes in inflation. Shortage of credit is increasing costs for companies and reducing consumers ability to spend. Declining house prices in the US and UK will have reinforcing wealth effects, as consumers become poorer they will spend still less. Any in the UK, consumers are starting to become shit-scared of losing their jobs and their financial future.

Developing economies may have to contend with their own challenges driven by the rise in fuel and food prices. So much so that the IMF has warned that these are at significant risk from rising fuel and commodities. Inflation will batter the economy and measures to offset higher prices will be a drag on GDP growth (as high as 2.5% in an economy like Pakistan). And this is before we take into account the decreased demand in their major export markets–the developed world.

As a result, companies are missing their earnings and growth targets in diverse sectors such as information, retail, technology, transport. This in turn will lead to cost-cutting which means restructuring and lay offs.

So, a good time or a bad time for entrepreneurial ecosystem?

Three ingredients for success are having a market of willing customers, having a team and having access to capital.

Let’s start with markets.

For b2b startups, the world looks like a sticky place. It is true that with corporate spending diminishing, corporates will stick to existing vendors and reign in spending plans. This happened during the last crunch after 2001. Trying to sell enterprise software was virtually impossible between 2001 and 2003 and lots of firms went to the wall.

However, firms still spend. And today enterprise software is delivered SAAS with lower implementation costs and variable cost business models that don’t require an upfront cash investment. In fact, ROI on these types of projects can be measured in weeks rather than years.
So a SAAS startup may still find it can make a compelling case to an enterprise buyer.

Verdict: harder but not impossible.

For consumer startups the prognosis could be bad. The bulk of consumer startups make their money from advertising. And the advertising market is going to be hit hard. Just look at what has happened to the newspaper groups such as Trinity Mirror. Worse, consumers are going to start to spend less on holidays, flat screen TVs, clothes and well anything except food and essential fuel. Food and essential fuel (for heating or lighting not AC in your hummer, Mr Sixpack) are Geffen goods, so price rises increase demand.

However, consumers will still spend. And the internet remains a tremendously low-cost channel for the parsimonious. Can we see Internet commerce declining relative to traditional retail? No. The cost advantage will become more, not less, important. And with it, internet advertising of the performance-based variety will remain attractive to firms.

For any business, performance based online advertising is a no-brainer. It has a defined and distinct ROI. You only pay when it brings you value. In a down turn, cutting anything that brings you incremental margin doesn’t make sense. Anything dependent on display advertising might look shaky but if your startup can build an audience which in turn has sufficient attention to drive performance adverts then you might just have a proposition. It is not surprise that Internet advertising (by which I include mobile) is, according to Morgan Stanley, the only advertising medium exhibiting any real growth.

Verdict for consumer-facing start-ups: Tough but not insurmountable and better than being a high st retailer, local newspaper, SUV dealer…

The second leg of this wobbly stool is the team.
But guess what, with corporate’s tightening their belts the perks of large company employment (such as air travel and bonuses) are going to disappear. BigCo will also be getting rid of non-core staff in a frenzy of cost-cutting. All this means more people in a labour market for any firm still in a position to hire. Now, you may not want the 20 year veteran of some unfathomable bureaucratic process joining your semantic technology start-up. But you might do worse than an experience HR exec helping you with people issues, or a part-time financial analyst to model out your business, or even tactical marketing staff to execute on whatever PR and marketing you’re going to do well.

It’d be fair to say that the hiring environment will get better not worse for start-ups. Lots of talent coming out of companies, prepared to work on contract and for results.

Verdict: good for the entrepreneur

The third leg is the availability of capital. Now venture capitalists are not like other private equity firms. Private equity relies heavily on leverage to produce financial returns and leverage (borrowing) is drying up, and what is available is rather expensive.

And with all the kerfuffle in the financial markets, won’t investors start pulling funds from (or indeed stop putting funds into) VC funds? That is an unlikely outcome for a couple of reasons.

The first is that once invested in, a VC fund is locked up, typically for 12 years. That is there is no way of getting your money back until the fund starts making distributions. So funds who have recently closed have stocked up for investments in the lean years ahead.

The second reason–and this applies to any funds looking to raise new funds–is that pension funds need to invest their pensionholders money. They can’t just stop. And they take a portfolio approach to investments, diversifying across asset types, time and geography in order to eliminate volatility. With so many asset classes volatile and trending down and stock markets across the world looking like they are about to settle into a period of unsettling choppiness, vc may not look like such a bad asset class.

After the tech bubble in 1999-2000, VC went out of fashion. Returns were terrible and funds were stung by overpaying for weak deals that still live with them today! European VC is still a pig of an asset class. According to the EVCA, pooled VC returns in Europe were 4.5% in 2007 compared to 32.3% in the US; and over ten years such returns were even worse: 1.8% in Europe and 18.7% in the US. Put it in context: you would have been better off leaving your money in a bank (even Northern Rock) than invest in Euro VC as an asset class.

That isn’t to say there aren’t firms with great results. According to Calpers, Index II, has returned an IRR of 33.4% while Index IV, the 2005 fund, has an IRR of 63.6%. And Balderton has scored two world class exits in the past year.

Even more attractively for the men with money, is that a tighter economic environment seems to encourage innovation with a healthy dash of parsimony. Skype,, MySpace were all outputs of the parsimoninous post-bust era.

Even though the NVCA has identified that the IPO market is closed (hat-tip Niederhofer), but even in their gloomy assessment this market will be open in 24 to 36 months. If you are an entrepreneur starting now (or even starting last year), you aren’t worrying about an IPO until 2011/2 in any case.

So to the third leg of our stool the answer is possibly a mixed yes.
There is capital available. There are people looking to diversify their investments. VCs still have to invest. European VC has had a few successes and there are several younger partners with experience of the excesses who are keen to show returns.

So on balance, as we enter some of the ugliest economic conditions of my lifetime (at least that is what my elders and betters tell me), I would say that relative to other things (running a bank, airline or media company), the internet ecosystem is probably a relatively healthy place with good prospects.


One Comment

  1. alasdairbell
    Posted August 28, 2008 at 2:36 pm | Permalink

    Excellent post, now tell that to the Seedcamp teams…. 🙂

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  1. […] Revisiting the recession for start-ups Three months ago I asked what the recession would mean for start-ups. […]

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