Ask YC: Impact of Recession on Startup Financing?

Standard economic theory states that during financial crises, investors exhibit a "flight from risk" behaviour; certainly, one can imagine institutional investors pulling their money out of hedge and venture capital funds. However, this crisis also has the US Federal Reserve aggressively cutting interest rates, with the effect that capital becomes cheaper, given a fixed risk premium.

My guess is that venture capital will become harder to find, while companies which are profitable but need capital in order to grow (e.g., to buy more servers) will find that loans are cheaper. Seed funding probably won't be affected at all -- money for that generally comes from people who believe in what they're doing (and are seeking, in part, a non-financial payoff) rather than people or organizations which are trying to maximize their profits.

I was just talking about this today. I believe common investors will want to see a working business model earlier in the product. The potential for early revenue with real customers (i.e. not ads) will be more attractive.

I think it's unfortunate. Capital intensive start-ups will be at an even bigger disadvantage.. in this case, I would agree with andreessen: raise as much as possible. I've always believed in creating value before you capture any, and that will be more difficult if you have to focus on your business model early on.

How is YE doing?

There were a few talks about this at BarCampNYC this past weekend (http://barcamp.pbwiki.com/BarCampNYC3Day1).

The consensus was it will probably be easier (in the short term, anyway) to find VC funding now that investors are fleeing real estate and need to put their cash elsewhere.

Tech actually looks good now, compared to other investment options.

How is YEurope doing? Serious question.

Very good question.

I remember that in DLD there was a session about this topic. The consensus was that Private Equity firms (or those that invest large sums of money) will get hit much more than VCs, and as a result the bigger the startup the more at risk you are. I also recall that Morten Lund claimed in the panel that a recession might prove to be beneficial (at least as far as Angels are concerned), because according to him, it will separate the great startups from the mediocre ones.

In my opinion, a strong recession, might cause valuation to go down, but it shouldn't affect early stage startup too much, because their backers usually look at a long term investment period.

It is interesting to say whether it would hurt or help vc and seed funding. My theory is that it will help. Seasoned investors have seen recessions before, and just switch to investments that provide the best reward. I think as a credit crunch exists, I think competition for those funds will become slimmer because less people can afford to take the risk of a startup which means it will be easier to get those funds.

You may actually see more funds available than normal. Could be great for our startup, (www.propertystampede.com).

you have to ask what is riskier a bunch of guys and gals fighting for their first chance, or a bank full of big wigs that have f'd up and are trying to refinance? Most recessions are caused by over production or over speculation of some sort, this is different, this is about the banks (low interest) money screwing up big. we may find that right now startups and companies are less risking than banks and loans.

Last time, investments went way down -- but that was at a time when technology startups were perceived (somewhat inaccurately) as being part of the economic problem.

It doesn't appear that this will be an issue this time.

Even during the Dot-Bomb, some notable startups were able to mature and flourish; the ones that come immediately to mind would be Google and Flickr.

I think all is not lost. At least not until we're all fighting over who gets to eat the last mudcake.

seed funding from the people like YC may not go down - VC funding may slow down temporarily - but if the startup has something innovative and unique stuff to offer then funding shouldn't be a problem ...

From talking to a few VCs, I don't think they're having any problems raising money, and even if they were, there are a lot of funds that are already set to invest over the next few years. (I haven't talked to any in a few weeks, so the former part of that statement might change/have changed.)

I would guess angels would be more affected. These are individuals, who might have lost a chunk of their money in the market and/or lost a shit-ton of equity in their homes. They might be scared more into preservation mode.

A recession impacts venture capital in two main ways:

1) Reducing exit potential 2) Reducing available capital for new funds

The first is simple. In a recession, capital is more scarce. Cash on Balance Sheets shrink. This makes it harder to find buyers (as in acquisitions - think YouTube by Google). IPOs are also less successful because of depressed stock market performance. PE ratios generally decline, making these exits less attractive.

The second is more complicated. Since capital is more scarce, finding investors for new funds becomes more difficult. Venture capital (and all of private equity) is viewed as a risky asset class. In a recession, portfolio managers usually cut back on riskier investments, favoring safer investments, such as stocks and bonds.

However, VC funds are committed funds, meaning that once a fund starts, that money is there whenever it needs to be "called down." In this respect, recessions don't impact startup funding because the money has already been earmarked. Since the last two years have seen LOTS of money poured into VC with LOTS of additional funds created, I don't expect to see a significant slowdown over the next 1-2 years. If the recession lasts longer, or if exit opportunities change substantially, this may change.