Entrepreneurs: brace yourselves for a tough 2008

The refinancing bonanza shows signs of a slowdown.  Investors have done a ton of deals in the last two years and tend to operate poorly in uncertainty.  What can entrepreneurs expect in the year to come ?  Entrepreneurs should brace themselves for tougher times and make their cash work even harder.

I would bet that at the moment the funds of most VCs are showing a nice positive paper IRR on the back of numerous up-rounds and possibly even some exits.  I sense that most of the industry is feeling pretty chuffed. And as per this year’s favourite video, raising Series A apprently only takes an engineer, some pizza and some beer.  But as a market practitioner I see tougher times ahead.  Whilst comparisons with the previous bubble are vastly exaggerated, the market will cool down.  [As an aside, read Kopelman for a good laugh on how good the press is at timing this].

The adjustment is likely to be gradual but clear.  If you did not go through your first bubble, make sure you read carefully the reports of companies falling into the TC Deadpool.  To take one startup close to home, look at Keith Teare’s Edgeio, whose demise was documented by Arrington.  No delays on product, so if you were a technically minded founder you would boe forgiven to think that you have performed well.  Unfortunately usage and revenue milestones were not met, with immediate consequences.

What am I driving at here?  As en entrepreneur, you need to be clear about a few things.  I am going to be uncharacteristically direct in telling you exactly what top expect:

  • getting in bed with VC money is a demanding engagement – you get more cash than otherwise and you are asked to run for the big exit.  The terms of the contract are that you generate value milestones that allow you to get refinanced at a pre badly diluted.  There is a good take on this on Kevin Burton’s blog.
  • Bad VCs will be the first to rush for the exit — when the going gets tough, having a financing partner who can see the long term vision and is aligned with you on strategy becomes critical.  If you take in investors who do not fundamentally get your business or who are themselves unstable, you are likely to suffer badly when your market take a year or two longer to materialize.  Make sure you choose guys who get it.
  • Even good VCs will cut your funding when your market opportunity does not materialise — now we are all willing to take the long-term view on massive upside, too-early-to-tell companies.  But to be clear, the disciplined VCs will actively cut capital allocations to underperforming companies early on.  If you don’t believe me, have a look at the survival rate in Sequoia’s early-stage portfolio.  Starve the losers of funding and follow the stars, that is what we must do.  See Villalobos and Payne.  Like good traders, we need to cut our losses and ride our gains (which is against human nature but critical to producing good returns).  Failure is a natural by-product of what we do.  Read Fred Wilson’s (somewhat self serving) post on this.
  • You CAN do more with less — easy to say but almost systematically true.  If you are in an early market and can sense the funding market tightening, do fewer things better and buy yourself runway.  As Ken Morse will always tell you, CIMITYM (Cash Is More Important than Your Mother, with apologies to all those who have lost their mum).
  • Funding downturns last — don’t plan for 2 quarters of drought, plan for 6.  On that note I am somewhat with Donna Bogatin in her fairly sharp review of Mike Arrington’s recommendations to startups: cash does matter.

I am not going to get into the boring and overdone good-versus-evil discussion (of course many of us are delusionally untalented
Pygmalion-style A-types who are entirely responsible for every success
in their portfolio and come down from the heavens, god-like and dressed
in gold lame jumpsuits, to impart death upon the underperformers for
the greater good of the entrepreneurial community).  We do what we have to do to get the best returns.  Whether we do it in a transparent manner and with respect for our entrepreneurs is what matters.  Whether we stick with worthy underperformers during tough times is what you should care about. 

I would not recommend going down the Keith Teare route of slamming your VCs (here is Keith in VentureSource: "I would say it came down to
lack of vision on the part of investors to see the platform as part of
the future".) but rather understand the rules of engagement.  VCs may suck, but they are still to closest proxy to a vaguely smart investor in early stage tech.  As the market gets tougher, you will need to get to grips with the dark underbelly of the beast.

So choose your partners well and may the force be with you.

<—- me in my 2002 outfit

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