The famous Spanish philosopher, George Santayana,  once remarked that ”those who cannot remember the past are condemned to repeat it.”  So, a natural question in these times of financial turmoil, when it is hard to stave off a sense of impending doom, is: how will this “bust” be different from (or the same as) the dot com bust that began in 2000?  More precisely, what will be the differences and similarities as they relate to venture financing and early stage companies in the Pacific Northwest?

Crystal-ball gazing (specially when combined with generalizations) is always a humbling exercise, and I am sure there are many others, but here are six things I think will be different and, for balance, six that I think will be the same:

Differences:

1. Early stage companies have stronger balance sheets and lower burn rates.  In contrast to the Dot Com Boom years leading up to the bust, most early stage companies that have taken venture funding have raised at least 12-18 months of anticipated cash, and haven’t  immediately take on venture debt to bulk up their cash hordes.  Similarly, companies have been more conservative in building headcount and marketing spend that isn’t ROI driven, so their monthly burn is lower.
2. There has been less valuation inflation in the last few years, so down rounds, if they come, will be less draconian.
3. Because there has been less of a sense of urgency in recent years to “get big or go home,” as companies go through the always painful process of reducing expenses, there will be fewer RIF events.  That said, one of the “lessons learned” from the last bust was that it is far better to do one, early, deep RIF, than a series of small ones, always hoping that it will be the last.
4. Venture capitalists are better positioned to fund follow-on rounds.  Venture capitalists have always “reserved” for portfolio company future needs, but during the boom, when companies were being acquired or going public literally within months of a round, and there was always someone else who was panting to lead the next round, venture capitalists significantly underestimated the timing and extent to which their companies would need fresh capital.  Many simply didn’t have any more resources at their disposal.
5. Fewer early stage companies have been funded that don’t have a clear business model.  I say “fewer” because there are still a number who have substituted “unique visitors” as a proxy for revenues. It drives me crazy when I hear a presentation where the CEO says “we haven’t been focusing on revenues to this point, but you can see how powerful this model is,” or words to that effect.  This is just a less virulent strain of the “eyeball-itis” that struck in the laste 90′s.
6. This downturn is likely to be deeper and more prolonged than the last one.  This looks like a Category 5 hurricane bearing down on us (maybe they always look worse when you are in the moment).  We have the lessons learned from the last downturn to help us weather the storm, but it would be best not to underestimate its severity.

Similarities:

1. Companies, large and small, (and, this time, consumers) will dramatically curtail “discretionary” spending, especially with early stage companies.  We went through an era when customer IT budgets plummeted (“we are only going to fund our top three IT initiatives this year, so don’t even talk to us if your product/service isn’t on the list”), and companies didn’t want to buy from early stage companies (“how do we know you guys will be around a year from now?”).  As they cut back, companies will become even more ROI driven (higher hurdle rates, shorter payback time periods).  This is good news for early stage companies that can demonstrate clear ROI advantages.
2. Weaker companies will lose some great talent, and stronger companies will be the beneficiaries.  This will redound to the benefit of the Microsofts and Googles of the world, but early stage companies with  strong balance sheets and solid business models will get more than their fair share.
3. Venture capitalists will tend to husband their resources (both capital and human) to support their existing portfolio companies, and will be reluctant to invest in “someone else’s deal.”  There was a period following the last bust when virtually all follow-on rounds were “inside” rounds (existing investors), because no one wanted to take on someone else’s problems.  That will be true to some extent this time around as well, but there were some notable missed opportunties to become a new investor in a follow on round from that era that will cause venture capitalists (including Madrona) to keep an open mind.
4. Some great companies will be formed during this period.  We certainly saw that in the years following the last bust, and it will be true this time around as well.  In fact, in many ways this is a great time to be starting a company (ok, maybe I should say in “some” ways).  Companies at the very earliest stage almost always have very low burn rates and have not budgeted meaningful revenues in the next 12-24 months, so they 1) aren’t desperately trying to achieve what may now be an unrealistic sales target and 2) it is much easier to control your expenses than your top line. 
5. Venture lenders will move aggressively to protect their collateral.  One of the important (maybe most important) underlying assumptions of banks that lend to early stage companies (ie. those that are not cash flow positive) is that the venture capitalists will continue to fund the companies that have taken down the debt.  When it didn’t happen during the last downturn, venture lenders quickly moved in (or, more accurately, quickly moved out the cash), to protect their interests.  Most, but not all, debt agreements of this type entitle the lender to “sweep” the cash (whether it is in their bank or you have put it in another bank) under certain circumstances (usually fairly vague), and as economic circumstances become more difficult and cash balances (the best form of collateral) decline, expect to hear about some unpleasant suprises.
6. Many companies with weak business models (or weak teams) will go out of business or be sold for peanuts.  That’s no different from any other time, but the pace will  accelerate.

This entry was posted on Friday, October 24th, 2008 at 1:47 pm and is filed under Big Picture Stuff. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.