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What Is The Effect of the "Pending" Recession on Venture Capital Financings of Private Companies?

Q:  What is the the impact of the U.S. economy going into a (possible) recession on venture funding for new startups?

A:  (Jason).  Somewhere my undergrad economics professors are shuddering as I type this answer.  I won’t hold myself up as an professional economist or fortune teller, but there are some takeaways that have have been learned from prior downturns.

The first takeaway is that a lot of the effects of a recession are dependant upon how deep and long the recession is.  For instance, a longer recession will certainly lessen companies desire for buy advertising, whereas a shorter one may not.  Given advertising’s importance in the revenue models of many vc-backed companies, a protracted downturn will impact their revenue growth and decrease their chances for achieving profitability.  If a VC has a lot of companies in its portfolio that rely on advertising revenues, then it is possible that they’ll have difficulty supporting their companies financially if all of them suddenly experience longer roads to cash flow break even. 

Furthermore, companies will start to conserve cash to maximize earnings and this usually means a reduction in IT expenditures.  Venture companies who rely on enterprise sales will be affected similarly to ones analyzed above.

Along with companies trying to conserve cash, they will tend to acquire less companies and the ones they do will be for lower prices.  IPOs will not be possible in the choppy markets that are common during a recession.

All of the above will cause a lot of noise, grumbling and folks on MSNBC talking about how the sky is falling. 

Now how does this all affect VC financings?  Well, history would tell us that VCs will put less money into funding companies, converse cash and wait until the acquisition and public markets open up a bit.  With a lack of good exits, why would a VC want to invest in a company?  However, that’s never made much sense to me, especially if we limit investments to early-staged companies.  I’ve always thought the best time to invest in young startups is when things are choppy.  You usually can invest at lower prices, hire folks for less than you normally would, etc.  Also, I’d never expect an investment to exit in the near future (1-3 years, for sure) and therefore the company will be well positioned to exit at the end of the recession.  If you wait until the recession is over, you are already paying too much.

So bottom line is "we’ll see."  The last go around saw a tremendous drop in venture investing during hard economic times.  If i was a betting man, I’d probably still expect the same, but I can see a strong argument for continuing to invest regularly through the cycle.

January 23rd, 2008 by     Categories: Uncategorized    
  • francine hardaway

    I'm not a VC, but I'm an angel and I agree with you about early stage companies. Our comanies sometimes take 5-10 years for an exit, and the recessions come and go. Fear does make things cheaper, however.

  • Tom

    This is your economics lecturer talking…your training did you well: you expertly identified possible scenarios, while simultaneously avoiding advocating anything as most likely. You must have gotten an A+ in GreenspanSpeak!

  • Alain Raynaud

    With a recession coming, small-time angels will dry up first, because they see their money shrinking. That will hurt very-early stage startups. As exits will close as well (IPOs, but mostly acquisitions), conservative VCs will also be more reluctant to invest.

    However, a recession is a great time to start new companies. It gets rid of all the noise and spam, so it's easier to get noticed, find good people, etc… Only the strong survive when there is a recession. During the dot-com bubble, everyone seemed to succeed, so it was hard for legitimate businesses to emerge.

  • http://www.jointhesolution.com/earn AZMike

    Loved your article! It could have just as easily been focused towards a real estate crowd or a stock market bunch.

    That being said, if there was no risk there would be no profit and any bank would finance it.

    Going into a recession? Half of us out here think we are already in one and the other half “…wants fries with that”. I know this time last year I was wondering when business was going to pick up, and now I am voicing the same concerns.

    (I think I need a new career, “How much do GreenSpanSpeakers make?”)

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  • solanki naresh

    howere…recession is not in middle stage..industry has to suffer this recession..in this period venture capatilist has chance to absorb the oppertunities in world capital market………