US Economic Risks (Sept 2010): Impact on Investors & Entrepreneurs

This post was originally published in a shorter (more sensible) format in the Wall Street Journal online. If you’re short on time click on the WSJ link and read the 990 word version there. Otherwise, grab a cup ‘o coffee …

Clicking on any graph below will take you to that article.

One year ago I predicted that in 2010/11 the economy, far from being on the path of permanent recovery was on a temporary resurgence and there was a strong possibility of a “double dip” recession. My advice to entrepreneurs was and is “when the hors d’oeuvres tray is being passed take two” (e.g. raise money now to weather any storms).

My original thinking from Oct ’09 was, while I didn’t (and still don’t) have a crystal ball I worried that: consumers were over-stretched with debt (and make up 77% of the economy), unemployment would continue to rise, which in turn would drive the stock market south and cut the rate of M&A activity and VC investment even further.

Sounds obvious now, but as I wrote the original piece the DJIA had already come roaring back from 6,600 to 9,865 so it was certainly against conventional wisdom. It eventually closed at 11,204 in April ’10 before sliding back around 10,000 as I sit here and type. Well before the recent decline I sent out a Tweet that said, “Many will disagree but I still fear deflation, structural unemployment and political malaise.” Scott Austin of the WSJ (worth following) saw my Tweet and asked me to go on record with my rationale.

So I agreed to offer my current thinking on the economy and what it portends for the VC industry & fund raising for entrepreneurs.

Let me preface by saying I obviously have a vested interest in being wrong about tough times ahead but as the old saying goes, “hope for best, plan for the worst.”

• 2010 has been a great year for startup fund raising: Let’s face it, 2010 has been “the year of the super angel / seed funds” that was arguably first popularized by First Round Capital but has gathered steam with the success of great firms like Floodgate, Founder Collective, SoftTech VC and more recently Felicis Ventures, 500 Startups and incubators like YCombinator & Betaworks. The prices of angel deals have recently crept up, VCs have also gotten their checkbooks out again, frothy deals are happening and people are feeling bullish. I heard an entrepreneur last Friday tell me that after he appeared on AngelList he had a funding frenzy with one investor whom he had never met offering to fund him after just 15 minutes on the phone.
• We’re still caught in the “post recession bounce”: What’s happening is that the angel & VC community is still feeling good from having bounced back from the nadir of the famous “RIP Good Times” funk that we felt in 2008. This has been especially true for angels or seed investors as there is a new thesis that less capital is needed to start Internet companies so more money is being spent at this phase of the funding lifecycle.
• We have structural employment issues: The official unemployment rate in the US is hovering just below 10% but “true” unemployment is much higher when you account for those that have stopped looking or taken part-time employment and in key states like California and Michigan we’re downright hurting. 45% of all unemployed people have been looking for jobs 6 months or more — this is unprecedented. And when you further strip out any employment created by government stimulus that is uncertain to continue going forward we know that the country is not creating enough jobs. We’d have to hit 2.5% GDP growth just to stand still on employment! And last quarter we now know grew at just 1.6%.

• Personal balance sheets are still stretched: The problem in the US starts & ends with “consumerism” that was fueled by artificially high real estate prices, which drove up spending and the stock market. The reality is that we’ve spent beyond our means for years and the process of “de-leveraging” (increasing savings by spending less) has begun. We took $2.3 trillion out of our homes and spent 2/3rds of it on flat screen TVs, trips to Hawaii, time shares, Apple products and everything else we couldn’t afford. The spending contraction is inevitable in a period of declining real prices of housing, high unemployment and tightening credit.

• The housing market is not recovered: Sales in existing homes in the US fell 27.2% between June and July 2010 (and 25% from a year ago). Sales fell in every region of the country with the Midwest suffering the worst at 35%. We also have an overhang of foreclosures either held by banks or consumers who have not yet “blown up” but are increasingly behind on payments. Anybody wanting to understand how “oversold” the housing market is should read The Big Short.

• Government programs led to the law of “unintended consequences”: Our housing slump now is continuing well beyond where many people had hoped it would be by now. Some of the delay is just overhang of a bad market but we may be delaying true supply/demand matching through the well-intentioned government’s attempt to stem price declines. The government had a tax incentive for first-time buyers that expired April 30th, which many people believe “pulled forward” demand rather than improved the market.
• Washington is in no mood to take stimulatory action — for a long time: While there was a momentary unity in the US government for bailouts & stimulus spending that were initiated in the Bush administration (many people conveniently forget this now) and continued under Obama, it is clear that this era of consensus is over. Keynesians will argue that this is a bad thing and fiscal conservatives will argue that it is a necessary discipline. Either way, the gridlock that is now the US congress will prevent any real economic responses and it seems likely that this political malaise will last beyond the 2012 election as the Republicans look to make big gains in the 2010 mid-term elections.
• The Fed: That leaves the most likely response to any economic weakening to be dealt with by the much less political Federal Reserve. With interest rates near 0% the Fed can’t cut interest rates to try and stimulate the economy and drive good inflation (or avoid deflation). They would need to turn to non-conventional means to spur the economy such as “quantitative easing.”

“Consumer spending may continue to grow relatively slowly in the near term as households focus on repairing their balance sheets. I expect the economy to continue to expand in the second half of this year, albeit at a relatively modest pace.”

• State & local governments are going to be hit: One likely result of the economic crisis and lack of political alignment in Washington is further cut-backs at state and local levels because unlike the federal government they can’t print money. This spells further unemployment, cuts in services and a further retrenchment in middle-class spending and housing prices.

• And the tax changes for 2011 could cause a further end-of-year sell-off: Another factor often not discussed is that the capital gains tax increases coming into effect in 2011 are might just lead to a stock market sell-off in Q410 as investors “lock in” gains at a lower tax rate.
• The initial vulnerability will affect angel investors: The stock market and real estate impacts usually hit angel investors (excluding angel funds) before they hit VCs so that is where the initial hit will likely come again this time. This class of investors is more diversified across categories plus is investing personal money and therefore feels the hit in assets declines first. Also, if there is a lowering of M&A activity this will lead to increased financing needs for startups driving higher failure rates or increases in “adverse terms” entering future financing rounds. Either won’t bode well for angels if they’re also hurting on non tech investments.
• Many entrepreneurs could be caught in the “series A&B funding gap” Equally worrying for entrepreneurs if the markets take a turn for the worse is that even if they managed to get angel rounds funded they may run into a VC brick wall. VC funding is definitely back from the constipation that was 2009 replete with frothy valuations chasing dreams of the next Facebook, Groupon or Zynga. But a double-dip recession couple with contracting VC market highlighted by Paul Kedrosky, a Kauffman Fellow, will surely bring back a period of inertia.

What does this mean if you’re an investor?

If we do have a double-dip recession or a “lost decade” the investors who have put money to work in capital efficient companies at reasonable (not frothy) valuations will fare the best.

The investors who in my opinion will be especially vulnerable are those who chose to spread too many bets or didn’t reserve enough for follow-on investments. Massive market corrections require hands-on investors who are good at: building management confidence in tough times, encouraging costs cuts, performing triage so that the strongest survive and helping shepherd co-investors into writing follow-on checks. You simply can’t do with with 50+ active investments for one person. I saw this first hand in the first dot-com crash.

What does this mean if you’re an entrepreneur?

If economic times turns out to be worse than they are today entrepreneurs who raised enough money in 2010 to weather a storm will be best placed to survive the second dip or the long lack of recovery. Additionally, those who run lean operations and raised money from supportive investor bases will be best positioned. Having a combination of entrepreneur-friendly angels plus deep-pocketed VCs might be just what the doctor ordered.

In the end

I’m a venture capital investor so I will still be looking to make investments. My time horizon for investing is 7–10 years so today’s economy doesn’t affect my exit prices BUT I need to be sure the companies I invest in reach the promised land. I will continue to look for “lean” teams, co-investors on deals to help get through any rough patches and entrepreneurs who have the resiliency to make it through whatever the economic conditions throw at us.

The tech industry can help with job stimulation, but we’re not immune to macroeconomic trends.