Tough times ahead for Silicon Valley?

Financial crisis puts squeeze on tech sector start-ups.

John Kehe/Staff

For Win Betteridge, the nationwide financial meltdown has meant one thing: opportunity.

At a time when many people have been guarding their cash, the young entrepreneur decided to go shopping for other websites.
Mr. Betteridge is CEO of Genesis Interactive, an Internet company in San Francisco that runs, a social portal for video-game enthusiasts.

Eager to boost traffic to the site, he targeted an online video site called GameVee.

A clash of the titans this wasn’t. Both companies had similar size staffs and were new to the Internet scene. But Betteridge’s site had a larger following and was flush with cash from a successful round of fundraising in April. With the mood among venture capitalists turning increasingly cautious, GameVee’s money-raising potential was far from secure. In the end, for a relatively cheap price, GameVee decided to sell for about 2 percent of Genesis’ stock, valued at about $125,000.

“For companies that can stay afloat, there is opportunity,” Betteridge says. “This is very much related to the financial downturn. If you’re smart, the strategy might be to acquire.… Some companies that are in pretty desperate straits.”

After celebrating his acquisition and merging personnel, he did something that tells of lean times ahead: He cut his staff by 20 percent.

Betteridge’s aggressive conservatism is in many ways emblematic of the current uncertainty in the Silicon Valley, where young technology companies are preparing for trouble in the months ahead with less investment capital on the horizon.

The future was foreshadowed almost by accident earlier this month, when Sequoia Capital (one of the early investors in Google) sent a slideshow to its portfolio companies that featured a picture of a gravestone and the title: “R.I.P. Good Times.” Soon after, many in the technology sector were talking about what, exactly, was in store for Silicon Valley.

The TechCrunch blog, which offers analysis of tech start-ups, created a “Layoff Tracker” to chart the predicted flood of industry-wide downsizing.

In addition, venture capital investments in US-based companies have dropped over the course of the year, with a 7 percent fall in the third quarter alone, to $7.37 billion, according to Dow Jones VentureSource.

Whether this is indicative of a long-term decline in financing, though, is far from clear. The amount invested last quarter was less than any quarter of 2007, but more than in 2006.

“The capital is there. The question now is just ‘where do you put it?’ ” says John Taylor, Research & Financial Affairs Executive at the National Venture Capital Association (NVCA).

A more concrete source of worry involves the increasing inability of the venture capital firms to profit from the innovative companies they nurture. In the past three months, only one venture capital-backed company went public and only six have done so this year, down from 86 in 2007. Acquisitions of small start-ups from traditional buyers like Yahoo have also stalled.

“I’ve been following this for 35 years, and I’ve never seen a period where there is a lower amount of speculation,” says Scott Sweet, senior managing partner of IPO Boutique, a specialty IPO advisory firm based in Florida. “There is just no market for newer companies, especially if they show losses.”

Instead, venture capitalists are focusing their resources on the financial health of existing ventures that, in years past, would have been sold or gone public by this point.

Venture capital firms are also different from the over-leveraged investment banks of the world in that they actually have money – cash raised over the last couple of years in large part from pension funds and endowments.

The prime concern is whether venture capitalists will be able to raise additional money once the current stockpile runs out. An NVCA report shows that fewer venture capital firms were able to raise money in the third quarter than in previous years.

But venture capitalists and analysts are quick to point out that top-tier firms such as Sequoia will most likely face no real difficulty drumming up money for the future.

For Gregory Gretsch, managing director at Sigma Partners, a venture capital firm with offices in Menlo Park, Calif., and Boston, less investment down the road is actually positive. “There is a belief within the investor class that these things take a long time, and that this might be an expanded bad market,” he says. “The bar is going up.... Gone are the firms that will just pay up [for any new company].”

As a result, start-ups that do receive funding will probably make better products, have less expensive valuations, and a greater probability of generating big returns for investors.

“This is wonderful for the venture business,” Mr. Gretsch says.

For serious investors, history may serve as a useful guide. Today’s technology sector, like most parts of the economy, is cyclical.

The current crisis, though, is unlike the dotcom bubble of the late ’90s when Internet company valuations were stratospheric while few paid attention to how to actually generate revenue.

Today, the fundamentals of technology businesses are stronger, and much of the difficulties Silicon Valley companies face have more to do with overall consumer spending than unrealistic business plans.

In fact, the current economic slump may in some ways lead to better innovation, suggests Brett Bullington, a former executive at Excite@Home turned angel investor and Web entrepreneur.

After the tech bubble burst in the late 90s, he says, “a lot of companies quit innovating,” but this simply opened the door for a company like Google to make its mark.

“The same thing is happening to business models,” Mr. Bullington continues. “There are cutbacks at [companies including] eBay and Yahoo.... [So] who is going to fill this need for creativity? Clever new start-ups that don’t necessarily need massive amounts of cash.”

While every investor is still looking for the next Google or Facebook, once-in-a-decade companies are not the sole focus of investor dollars these days, notes Paul Graham, a longtime investor in young tech companies and founder of Y Combinator, a start-up incubator in Mountain View, Calif.

“Unless your site is something that can kick ass, you’ve got to have something you can charge for,” he says. “Ideas can either be practical and unsexy or absolutely brilliant.”

Adam Sachs, chief executive of Ignighter, a New York-based website that focuses on group dating (your group of friends goes and does stuff with a group of others) breathed a sigh of relief recently after securing $1.2 million in funding from “angel” investors, a funding source that is eluding many of his start-up peers.

“It was extremely, extremely scary to watch the market drop while we were asking for money. And angel money is even scarier. These are people who have watched their net worth decrease by a third or a half,” Mr. Sachs says. “If we had started a few weeks later than we did, it would have been much harder.”

Despite optimistic initial plans, Sachs says he’ll have to make his first chunk of investment dollars last much longer than he had anticipated.

“We are going to be really careful as we go into the future,” he says. “I’m just so fortunate to be here.”

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