Startup Fear Factor

In the past 10 days there were two venture capital forums in Canada. The Banff Venture Forum last week, and the Ottawa Venture and Technology Summit this week. Both featured many startups looking for investor exposure, and investors talking among themselves. I was at neither, since I am not a VC and, as a budding entrepreneur, I just don't see the point of trying to get accepted into these venues. After all, VCs are always available to meet and talk, but not to invest. Not now.

As I described in an earlier article, there is no investment because there is no visibility of profitable exits. It's very simple but it get obfuscated by rhetoric from the VCs not doing any new investing. Here are some quotes from articles from CBC and Business Week:

"Rather than sprinkling a little bit of money in 15 or 20 companies, most VCs now would prefer to put more money in eight or 10 companies and make sure those companies have a better chance to succeed."
-Neal Hill

Does this mean they did poor due diligence in the past? There was some of that, though they got away with it because the exits used to be fast and easy; they passed the weak companies off to others. To be a bit cruel, we can call this dumb money selling to dumber money.

...the companies that went public or got acquired went for smaller amounts of money, and took longer than ever to get there.

Nortel, to pick a local example, now has a market cap barely over US$800M. They do not have the currency to acquire companies, even if they had the desire to do so. With far less competition for acquisitions, those large companies that do have money prefer to wait for the desirable startups to become distressed or bankrupt and the pick up the technology, intellectual property and key engineering staff for a song from investors desperate for any return, even if it's pennies on the dollar.

"Maybe you do have to slow things down a bit to preserve a little more cash, but to create more steady business."
-Bernie Li

That is to say, to a VC's portfolio companies, you are not going to get any more money for a long time. You can choose to sink or swim.

Jason Calcanis has much the same message, coming from the entrepreneur side of the fence:

It’s my believe that the economic downturn will be much worse than it is today, and that 50-80% of the venture-backed startups currently operating will shut down or go on life-support (i.e. 3-4 folks working on them) within the next 18 months.

Make a list of every Web 2.0 startup to raise an A or B round and cross 80% of them off the list, because they will not make it to their next round of funding or profitability.

Ouch!

So there you have it. Not only is it not getting better for entrepreneurs, it's getting worse. Further, expect to see more VC firm go moribund or exit the field altogether. With no exits their existing funds are tapped out. No new money comes in because current investors are losing, badly, over past 5+ years. New investors are staying away because they don't see the pay off. With the current credit crunch there is even less risk capital available - so-called 'safe' instruments are now also proving to be brimming with unanticipated risk.

There is low to zero IPO activity in the US (adjacent chart taken from the referenced article by Bespoke Investments). Closer to home there were no IPOs on TSX in September following a year-long slide lower. Those that have IPO'd recently are under water. That's why investors won't subscribe to new IPOs.

But if IPOs and M&A activity dries up, then it trickles down to investors. One of the more popular statistics being thrown around right now is that fewer start-ups have gone public this year than in any year since 1977. With IPOs out of the question, that leaves an acquisition. And, if the buyer knows the company doesn't have the chance to go public, valuations are depressed, he said.
-Hrach Simonian, Canaan

It isn't all doom and gloom, so let's end with something at least slightly positive. For many years the tax regime in Canada has been unattractive to venture investing. It's as if the government does not want money to go into innovative and risky ventures. It is especially difficult for foreign money to operate easily in Canada. All this friction in the administration of taxation and investment, both for incoming and outgoing money, makes Canada a poor choice for investor dollars, unless a specific opportunity is so attractive that an investor is willing to take the pain.

The problem is not particular to any one party in power. Both Liberal and Conservative governments have been slow to act, despite a lot of lobbying from the financial and entrepreneurial sectors. Here are a couple of articles that reference tax law improvements, as suggested by Mark McQueen of Wellington Financial and John Ruffolo of Deloitte. If you are unfamiliar with the issue these viewpoints may be informative.

And finally, here is an example of how the problem cannot be solved. VC is investor money. With the market in the tank there is no investment. Cheerleading is frivolous and unhelpful. But thanks for trying.