What impact will the credit crunch have on venture financing for startups?

An entrepreneur asked me recently if I was concerned about the impact the credit crunch will have on venture financing for startups. I responded:

For high quality companies, the short answer is no. The more nuanced answer is that

(i) The credit crunch will impact venture debt (already has) so people can’t count on that to extend their runway, so should raise a bit more than they would have done
(ii) If the economy indeed slips into recession (as a second order effect of the credit crunch), then this will impact sales growth for many startups, whether selling to enterprises or consumers. This will also impact timelines to profitability, and hence amount raised. It will also likely cause some angels and some venture firms (especially corporate venture firms and firms with a shorter time horizon) to become less active investors.

At Lightspeed as we take a long term view towards the companies we invest in. However, we are urging them to be conservative in their revenue projections and hence cash planning (both from amount raised and from cash burn perspective).

GigaOm weighs in on the venture debt issue in particular

Fewer, costlier loans. No way around it, money is getting more expensive. As long as banks are licking their wounded balance sheets, they won’t make loans that carry even a whiff of risk. This could raise borrowing costs and complicate growth for capital-intensive sectors, like telecom.

A more immediate problems lurks in short-term lending such as commercial paper. Interest rates in that part of the market have recently risen from 2 percent to 4.5 percent for riskier companies, according to Businessweek.

Fred Wilson has a similar perspective on the venture capital market:

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).

Venture capital firms will get more conservative and they will urge their portfolio companies to do everything Jason suggests (and more), but they will also be there with additional capital infusions when and if the companies are making good progress toward a growing profitable business.

If you go back and look at the 2000-2003 period (the nuclear winter in startup speak), you’ll see that venture firms continued to support most of their companies that were supportable. The companies that were clearly not working, or were burning too much money to be supportable in a down market, got shut down. But my observation of that time tells me that at least half and possibly as much as two/thirds of all venture backed companies that were funded pre-market bust got additional funding rounds done post bust.

So if you run or work in a startup company that is backed by well established venture capital firms, take a brief sigh of relief and then immediately get working on the “leaner, focused, profitable” mantra and drive toward those goals relentlessly.

If, on the other hand, you are just starting a company, or have angels backing you, or are backed by first time venture firms that are not funded by traditional sources, then I think you’ve got a bigger problem on your hands. It’s not an impossible problem to solve, but you have to start thinking about how you are going to get where you want to go without venture funding.

I say that because in down market cycles, it’s the seed and startup stage investing that dries up first. It happens every time. Seed/startup investing is most profitable early in a venture cycle and late stage investing is most profitable late in a venture cycle. It makes sense if you think of venture capital as a cyclical business and it is very cyclical. Early in a cycle you want to back young companies at bargain prices and enjoy the demand for those companies as the cycle takes hold. Late in a cycle you want to back established companies that need a “last round” to get to breakeven and you can get that at a bargain price compared to what others paid before you. I’ve been in the venture capital business since 1986 (that was a down cycle) and I’ve seen this happen at least three times, probably four times now.

There’s another important reason why seed and startup investing dries up in down cycles. Venture firms don’t need to spend as much time on their existing portfolio companies when things are going well. A rising market hides a lot of problems. But when things go south, they tend to become inwardly focused. I believe we are headed into a period where venture firms will spend more time on their existing portfolio and less time adding new names to it.

Plan appropriately