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10/3/2008
12:40 PM
John Foley
John Foley
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Financial Fallout May Mean Fewer, But Better, Startups

Technology startups could be in for a bumpy ride as the financial crisis hits them from both sides. Venture funding could get -- almost certainly will get -- harder to come by, just as IT departments tighten spending. Here's how some startups will find their way through the mess.

Technology startups could be in for a bumpy ride as the financial crisis hits them from both sides. Venture funding could get -- almost certainly will get -- harder to come by, just as IT departments tighten spending. Here's how some startups will find their way through the mess.First, not everyone is hitting the panic button just yet. An article today in the New York Times makes the point that, according to some people in Silicon Valley, the "engines of innovation are still chugging along." It's a sentiment I heard repeatedly this week on a two-day trip to Palo Alto, where I met with startups, CIOs, and VCs.

"It's business as usual in our shop," says Doug Renart with Tandem Entrepreneurs, an early-stage investment company in San Mateo. "Our businesses are lean by definition, and we never banked on IPOs or mega-acquisitions. We also focus on low-cost products and services delivered directly to end users. So while consumer sentiment has some impact, we don't suffer directly from slowdowns in corporate spending."

Yet, it's impossible to ignore the predictions of rough times ahead as the financial markets work out their excesses and mistakes. "Ominous signs abound," writes the Times.

A recent report by PricewaterhouseCoopers and the National Venture Capital Association serves as a warning to tech startups and their VC investors. According to the report, there were no VC-funded IPOs in the second quarter, the first time that's happened in 30 years. One Silicon Valley financial expert I talked with said that he wouldn't be surprised if there are no more such IPOs during the rest of this year.

Among other things, that implies that emerging companies will have to stay the course longer as private companies. To sustain themselves, they'll need to become super-efficient in their internal operations, making the most out of every investment dollar already banked. "We're advising our companies to, within reason, conserve cash that they have," Hummer Winblad managing director Mitchell Kertzman tells me via e-mail.

We may see fewer new startups and more that are six, seven, or more years old. PWC puts emerging companies into four buckets: seed stage, early stage, expansion, and later stage. According to the above-mentioned financial expert, instead of three- to five-year exits (IPO, merger, or acquisition), the exit window for startups may be extended to as much as 10 years.

For IT departments that do business with startups, that's not necessarily a bad thing. CIOs prefer startups that have a few years of experience and bona fide customer references over two-men-in-a-garage operations. So, although VCs may have to pump additional funding into their portfolio companies and wait longer to see the fruits of their investments, IT departments are more likely to engage the lean, later-stage vendors with viable business models that result.

What about the newbies? Some Silicon Valley optimists say that money will continue to flow unabated into new ventures, but they're increasingly in the minority. A funding slowdown to seed-stage companies is likely as VCs become more discriminating. Indeed, there already were signs of that in the second quarter. According to the Money Tree Report -- published by PWC and the National Venture Capital Association and based on Thomson Reuters data -- funding for seed- and early-stage companies dropped to $1.6 billion in the second quarter compared with $1.7 billion in the first quarter. Similarly, there were fewer deals. That's noteworthy because the second quarter is typically strong for the newest of companies. It was the first time in six years that there was a dip from the first quarter to the second quarter in seed/early stage funding, according to the report.

There are two ways to look at a potential drop in VC-funded, seed-stage companies. One is that it could lead to less innovation in the IT industry -- a bad thing. The other is that fewer unsustainable concepts will get funded -- a good thing. Based on the many "me, too" products I see from startups, the market could use some winnowing. I recently heard a CIO say that he refused to do business with any more virtualization startups because all those point products are becoming unmanageable. Call it too much of a new thing.

Even so, there are many in Silicon Valley who will tell you that it's still a great time to be a startup. "We continue to like early stage enterprise software!" Hummer Winblad's Kertzman says. Indeed, in some respects, the barriers to entry are at an all-time low for would-be tech companies. Cloud computing -- software as a service, storage as a service, CPUs as a service -- makes it possible to start a company with little or no investment in computer hardware and data center facilities. Two guys with a credit card can dial up servers from cloud services such as Amazon's EC2 or S3, and be in full-blown product development in no time and at little cost.

Bottom line: Financial turmoil could lead to fewer tech startups over the next 12 to 18 months, but those that make it should grow stronger and more viable. And it will be hard to suppress innovation because the Web, on-demand cloud computing, and new business models -- delivering software via Salesforce.com's AppExchange, for example -- make it easier than ever to get into this business.

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