Jan 23 2008 by Jason

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.