"Nobody told me there'd be days like these
Strange days indeed, strange days indeed"
                    -- John Lennon

I have written on several occasions about the likelihood of a
correction and pull back in the venture market. I've also said that it
will be triggered by a correction in the stock market which drives
companies, in order to protect stock price, to slash costs and capital
expenditures. It works like a clock. It happened in 1987/89, 1991,
1999/2000 and now.  The good news is there is no mystery to this. The
bad news is it just hit full force over the past two weeks.

While
forecasting is next to impossible, it is pretty clear what this cycle
is going to look like. This is the first credit driven correction in
our modern history. All of the other ones were triggered by the equity
markets collapsing. Why is this important and what does it mean regarding duration?

Credit
is the oil that greases Main Street. Companies hit the equity markets
from time to time to raise capital. So when it shuts down due to a crash, firms can generally manage status quo using cash flow or their
debt facilities (working capital lines, equipment lines, etc) to get
by. However, a credit crisis is different. Companies use their credit facilities on a daily basis to
fund equipment, inventory, receivables and facilities. When credit
contracts, their businesses contract. They can't buy the equipment they need, fund inventory for
product to sell and such. This means that this is going to be longer
and harsher than before. The last credit driven crash was in the Great
Depression when all of the banks started to go under.

In equity
driven situations, investors need to feel that prices have gotten low enough and they will come back in (fear turns to greed). In
credit driven crashes, the whole system needs to "de-lever" and the process is longer and more complicated. The core issue is that families have too much debt. So, the debt needs to go away to fix the problem. Unfortunately, because of cheap debt, poor oversight and
general greed, this debt party has gone on way too long. Consumers are
underwater on mortgages and credit cards and the government is
approaching the trillion dollar nut. Fortunately, corporations are generally not as bad off though some will get into trouble.

So, how difficult and time consuming could this possibly be? Wipe out a large chunk of debt to get it to an acceptable
level and move forward. One little issue: this would bankrupt all of our
banks and send us into the mother of all black holes. So, how do you wipe out this debt without wiping out our banks. You have to do
it gradually. People and firms use cash flow and savings (remember that
concept?) to pay off debt  while cutting back on consumption. A number of families will be so underwater that a Chapter 11 elimination of their debt is the only way out. With each Chapter 11, the banks will become weaker (reduced lending capital base) and the
government will have to repeatedly step in to "recapitalize" the banks to keep
them solvent. This is why we see infusions, nationalizations,
guarantees and such hitting every month. The bad credit card debt hasn't hit hard nor other types (student loans, etc) so we are going to have a series of these crises rolling through the system. Credit will get harder to obtain as the banks increasingly experience these challenges.

Having consumers save is a good thing, isn't it? Yes, but when people save versus
spend, the economy contracts, putting more pressure on the debt loads as unemployment grows and less capital circulates through Main Street.  You reverse the trends from the past 10 years. Instead of borrowing to spend, consumers will be saving to pay down debt. However, as Japan showed, getting this debt down to acceptable levels can take 7-10 years.

They referred to this process in Japan as the "Lost Decade" in the 1990's. Jim Rogers has said that if we don't take aggressive steps and let institutions fail and accelerate the downdraft, we will see a "Lost Decade" in America as the government tries to orchestrate a softer "de-leveraging" process. Who knows…

Ironically, while this is painful, it is actually a very healthy process. It is eliminating excessive waste and spending. It is encouraging saving and adding fiscal discipline back into the picture. It also rewards well run, efficient firms and prunes the weak and incompetent. This is not the end of the world as some may espouse but it will be tough going for the next number of years.

As with the tech bubble, I believe that we will have 2-3 years of hard sledding. Sales will take longer, marketing budgets will contract and technology expenditures will be slashed. This assumes the government is able to stave off a nuclear meltdown scenario in which case, all bets are off. After the hard sledding, we will have another 2-3 years of modest growth. In year 5 or 6, firms and people will grow more confident and growth will accelerate.  So, entrepreneurs will have a good 5-7 years to build out their businesses and prepare for the next updraft. When this hits, there will be few competitors and a lot of money will be made. The key is being the last man standing.

The next post will be a synopsis of the various VC strategies to their portfolio companies to survive this 5-7 year period.

In reading through the recent Fortune article, The 50 Most Powerful Women, I noticed that half of them were in the Midwest. This included:

#2 Irene Rosenfield    CEO, Kraft
#3 Pat Woertz            CEO, Archer Daniels Midland
#7 Susan Arnold        President, Proctor & Gamble
#8 Oprah Winfrey      Chairman, Harpo
#9 Brenda Barnes     CEO, Sara Lee

This is a pretty amazing feat to have so many female CEO's & Presidents here given the historical glass ceiling in the executive suites. Hopefully, this is a sign of further good things to come for all of our daughters…especially if you live in the Midwest!

I love stories about entrepreneurs and inventors who overcome adversity, flirt with disaster & bankruptcy, only to end up hitting the long ball.  The Economist published a great article in May describing the Pixar story.  As usual, things did not start off in a very promising manner.

Entrepreneurs don't often realize how long it can take to realize their dreams. Pixar's predecessor started in 1977 as a computer-graphics company. By 1985, with losses mounting and no end in sight, the founders considered selling their firm to General Motors or Philips Electronics, who appreciated the firm's technology solely for its 3D rendering capabilities for auto and medical scan imagery. They won an Oscar in 1988 which brought them temporary fame but it would be several years until Toy Story would hit. It was not until 2006, 29 years after its founding, that Disney purchased Pixar for $7.4 billion.

You should click on the Economist article "Tall tales" link to see the entire article.  Well worth the read for those of you slugging it out in the trenches, wondering if the win will ever hit. This tale shows the power of faith and perservance as well as the role that fate can play. You also can never tell exactly what form or business model will lead to that success.

Interesting Piece from PEWeek:

"Why aren't VCs freaking out as Wall Street burns? It's a question that I've been asking for more than a week now. There is, of course, the usual litany of responses: we're long term investors, we invest in fundamentals, our LPs are going to be good for their commitments because they're so big and so various….

Then there's another train of thought: VCs and their portfolio companies have actually gotten smarter about business since the dotcom bust. I've identified a few ways VCs and their companies are doing business differently. Help me out, identify a few more.

1. Better Money Management: Milestones matter to VCs. Ask any entrepreneur, and you'll find it's likely he or she are getting money in tranches based on deliverables. Most tranches go through, even when milestones aren't met, but the process allows VCs a better way of keeping track of the progress of their portfolio companies. VCs are less likely to write mega checks in the early stages, many have raised the bar of proof points needed to get a big round. Money is also more likely to go to things that directly drive valuation increases as a smaller percentage of any round is going to PCs, servers and bandwidth.

2. New Sales Models: It used to be about "Big Game Hunting" and multimillion dollar site licenses. It's a model that was great for vendors: get all the money up front, then worry about delivering the product. But Software as a Service permanently transformed the way IT was sold. Now new installations are cheaper and can be scaled slowly. It's a model that's been adopted by IT appliance and PC companies as well. So when Datamonitor finds that IT budgets aren't going to rise in 2009 Datamonitor Survey , there's less reason to freak out. Most IT buyers have already planned their spend out: it'll be re-upping on the services they're already subscribed to.

3. Decreased Addiction to Advertising: The banner ad was a big part of any dotcom business model. When advertising budgets fell, hundreds of online businesses shriveled on the vine. Now, online businesses look less to online advertising for real revenue. Google Adwords had a big hand in that. Suddenly it was a lot easier to install advertising on your site, but it was also less lucrative. Nobody ever got rich putting up Google Ads, but at least using the service saves companies from having to hire expensive advertising sales people. The addiction to advertising has been broken and many companies are looking for other ways to make real value online.

4. Moderate Exit Expectations: If you're not looking to flip a startup to the public market, what do you care that Wall Street's investment banks are falling like dominos? Had this same crisis had happened 10 years ago, you can bet VCs would be pulling their hair out. But when there are already no IPOs, it's hard for the public market to get worse. When exit expectations are more reasonable, it's easier to keep cash burn in check. Startups are less likely to build out sales teams, for example, planning perhaps to later plug in to an exisiting sales organization via aquisition.

What else have you learned from the dotcom bust that's helping out now?"

Having been through two market cycles already, I have been waiting for the credit mess to filter down into the start-up world. To date, this effect has been minimal compared to that impacting Wall Street and the buyout world. I would expect this to change in the coming 8 months. The question is how it will happen, to what degree and what are the signs.

I will start off by saying that I am not a great prognosticator. The best I can do is explain how it has manifested itself in the past. So far, we have been buffered by the massive liquidity the Fed has poured into the market, pushing off the onset of a strong recession. When trouble hits, it will come in three areas. First, corporations cut back on capex. Second, corporations cut back on advertising and marketing. Third, corporate acquisition appetite wanes or grows more predatory in nature. The IPO also usually dries up, but that has tepid even during the recent upswing.

What usually triggers the pull back? While there are a wide variety of factors, the one consistent factor I’ve noticed is when corporate profits begin to decline, especially when they miss guidance on the Street. This causes stock prices to drop. Management looks to cut costs aggressively when revenue growth slows and they are watching their options go underwater. Marketing & advertising is one of the first to get cut back. This has been happening gradually over the past 12 months but has not hit with full force. When CPM rates plummet and key word buys shrink, you’ll know things have begun.

Additonally, Capex shrinks and decision cycles stretch out. Enterprise sales become painful. Software, hardware and large service deals all become more difficult.

Lastly, firms will increasingly find it hard to find suitors to buy their businesses. While the market is not as robust as last year, there has still been modest activity this year. Eventually, it will feel like there are no buyers for your firms or the terms that the buyers are throwing out are very predatory. We have not gotten there yet.

Now, it is possible that the Fed will continue to pump so much money into the system and the government will continue to bailout institutions that we never get to this ugly phase (until much later). However, credit card defaults haven’t hit, regional banks haven’t been going under so there are still several chapters to play out here.

While this may be helpful in understanding where we might be in the cycle and what signs to look for, the main question is “what to do”? This is fodder for an upcoming post…

Entrepreneurship is about attitude and perseverance.  Our CFO sent this over to me which I thought I would share for the weekend. It also helps to remind you what is important in life (family) and to keep things in perspective. Stick with the video as it is about a lot more than just another young sports prodigy. Enjoy.

"Pigs get fat, hogs get slaughtered" — old folk saying

What a two weeks it has been. Who knows what firm will be the next victim of Darwin.  I told you all to buckle up last June because things were going to be interesting. With the Fed letting Lehman go down, now everyone is starting to wonder about whether their bank, brokerage firm, etc be next. Confidence in the system has taken another hit. Lot has been written on this, so I will not jump in other than to say that this is what happens when the pigs become hogs (e.g. greed takes over).  While it is the investment banks and such getting taken out back to be shot, it could be any of us. Lose your moral compass and you will eventually hit the rocks.

What the heck does this have to do with VC and entrepreneurship (this time)? Well, it's a great reminder to be your own moral compass. What I mean by this is that when you create and sell something to someone else, look yourself in the mirror and do a reality check. Just because someone might be gullible enough or uninformed enough to buy something doesn't mean that you should sell it. I have seen way too many portfolio companies fail to live up to their potential, too many entrepreneurs fail to deliver what they promised to investors or customers and too many VC's not bring the value that they claim they will.  I understand everyone has to sell and that we are, to a great degree, in the dream business. But, if you know that your portfolio company is overvalued on the LP quarterly report or that your product doesn't really do what you claim with the customer, these will eventually come home to roost. Demand excellence from yourself and from your companies and if you come up short, find ways to continually improve to be what you want to be versus pushing harder sell the pig with lipstick.

Buffett's sidekick, Charlie Munger, said it best recently:

In my mind, money earned in this way (whether Ibanker, VC or entrepreneur) is Blood Money and relies on the Greater Fool theory. That is not how great companies are made gang. So, look in the mirror tomorrow and do a gut check…

"It was the best of times, it was the worst of times, it was the age of
wisdom, it was the age of foolishness, it was the epoch of belief, it
was the epoch of incredulity, it was the season of Light, it was the
season of Darkness…"
— Charles Dickens, Tale of Two Cities

While I wrote about my concerns on the coming part of the business cycle, I am actually quite positive about the flip side of this coin. These periods are not kind to existing portfolio companies, but create a very attractive environment for new venture investments. I believe that 2008, 2009 and possibly 2010 will be good VC vintage years. Some of the crazy pricing and activity we have seen over the past year or so disappear and more rational investing takes its place. These times are actually, I would argue, also positive developments for well managed companies.

1) fewer competitors are started
2) weaker competitors go out of business
3) Darwin forces efficiency and laser like focus in your business
4) this discipline continues on when markets open back up, making for more profitable exits
5) less capital consumed means more equity for the founders in the end

Sectors that do well are those with low average burn, those focused on performance (e.g. pay for performance models) versus "productivity" or intangible benefits, and those selling into less recession sensitive customer bases. Life is tough if you sell capital equipment, have asset intensive businesses, have high burn, have impression based ad models or sell into recession sensitive industries. You are going to see a lot of dead Web 2.0 companies that rely on advertising for their revenue.