The Insolvent Investor

Economic road sign spotted on 280...

I realize, as an entrepreneur, I am supposed to be unendingly optimistic. But lately, optimism in Silicon Valley has begun to seem increasingly Pollyannaish. It’s become harder and harder to attend networking dinners and listen to VCs, bloggers, Web 2.0 CEOs, Facebook app mavens, and iPhone app Illuminati prattle on about how they are going to change the world. I’m sure one or two of them will. But the majority of the other X-thousand sanguine entrepreneurs will likely soon be out of business.

Living in Silicon Valley, gilded by the riches of Google, Apple, Cisco, Facebook (?!), and the oracular VCs of Sand Hill Road, it’s hard not to feel a little insulated from the rest of the world. But Silicon Valley most certainly is not. Economic downturns (or depressions, as this current downturn may turn out to be) often start in one sector and spread to others. In this particular downturn, the poor felt it first – their real incomes had scarcely increased in the last decade and with the rising cost of fuel and food, they were hurting last year. Then it was the real estate sector, long the darling of the American dream (invest in a house and you will surely be rich one day!). Then it was the financial sector – greed manifested in too much leverage and too little diligence – whose collapse is coming to a head as I write this.

Next, will be the middle and upper-class consumers. The middle class-consumer – the engine of the American economy – is levered to their ears (mortgage and credit card debt) and simply has no more money to spend. The upper class consumer still has capital, but they will no longer be buying the same volume of luxury cars and superfluous gadgets that once adorned their palatial homes.

And that leaves us with technology. With middle and upper income consumers drowning in real estate and stock market losses, there just will not be much money left over to purchase yet another iPod whose batteries no longer completely recharge, or buy that extra pair of designer shoes online that they found via a Google AdWord. Sure ad spending is moving online at a quickening pace, but if consumer spending drops quickly enough, it will not matter.  People will be spending significantly less money for an indefinite period of time. This will cause a huge pull-back in brand advertising, and a somewhat smaller, but still potentially large pull-back in pay-per-click advertising (people will be simply buying less stuff, which could mean lower click-through rates or lower sales conversation rates or less total money spent).

So what does this mean for start-ups in Silicon Valley? I think there are three primary concerns:

1) If you have an ad-based business model, it may become a lot less profitable soon. Additional revenue sources may become a necessity.

2) If you need to raise more money it may already be too late. A and B rounds are getting harder to close and valuations are dropping quickly (full-rachet, anyone?). Seed financing and later stage venture money may hold up longer, but in general, Silicon Valley investors move in a herd. What to do? Reduce your burn and focus on making money.

3) If you thought someone might buy you, now they probably won’t. With equity valuation dropping, the cost of capital for Silicon Valley corporations like Google, Yahoo, and Cisco will be going up. Coupled with their own internal growth problems (no more free dinners at Google), there will most likely be many fewer acquisitions.

And for those who think, “this too will pass quickly, like 2001 and 2002,” it might be worth taking a look at Japan in the early 1990s. They faced similar challenges to the US and the Nikkei is still less than a third of 1990 levels.

Am I being too gloomy? Perhaps. But there is no doubt Silicon Valley is going to take a pounding.