Will Weakening Economy KO Web Startups?

[qi:053] Economy watchers see recession as more likely after Friday’s weak jobs data. What does this mean for Web 2.0 hopefuls, now readying themselves for the fall conference season and dreaming of a Club Penguin style acquisition?

The job numbers suggest generalized weakness not confined to a few sectors. The problems began with subprime mortgages and lax lending for private equity deals, but in an increasingly interlinked economy tech startups and the venture capitalists that fund them stand at risk too.

VCs want what hedge funds got

At the end of August, VC Keith Benjamin of Levensohn Venture Partners proposed that tech IPOs and the investors who launch them could flourish as the mortgage mess poisons Wall Street. Benjamin says the credit crunch could be “the catalyst to put tech stocks back into favor.” The idea is that money will move from investing via hedge funds and private equity back to technology, which has been under a cloud since the dot-com crash.

This may be more than wishful and schadenfreude-tinted thinking. A similar migration of capital happened after the crash of 2000, as easy money urged on by the Fed chairman and a glut of Asian savings created a global housing boom. Perhaps if the Fed cuts rates aggressively enough now, the damage from collateralized debt obligations (that is, mortgages bundled into investments) will be contained. Investors can take their money and target it towards tech, not just Web 2.0 startups, but also more sober investments like VMWare.

The pain may spread

But as economic hurt spreads, it seems increasingly unlikely that technology — whether tiny startups or big companies like Google — will handily weather an economic storm that could rage across countries and asset classes. The economy doesn’t play fair, so just because hedge fund managers, private equity dealmakers, and real estate flippers won big over the past few years doesn’t mean it’s someone else’s turn. It could be everyone’s turn to practice austerity.

The web startup economy is vulnerable most directly via a pullback in advertising spending. Online advertising has in the past been heavily dependent on financial services. Half of Nielsen’s top ten web advertisers from July were mortgage or credit-related marketers. Financial services ads account for 34% of all impressions. As mortgage companies go out of business or retrench in an era of tighter credit, online advertising will suffer, and so will the sites and services that depend on that for revenue.

Worse, a credit contraction in one sector likely means tight credit and lowered spending in all sectors. It’s not that the money from hedge funds and private equity needs to find another place to go; it’s that there is altogether less money available. As those with assets refuse to lend them on any but the finest terms, tight credit means potential borrowers, whether businesses or consumers or investors, have less money to spend and lend.

Do we need a recession?

Some bulls look at weak job numbers and rejoice, thinking this surely means an aggressive Fed rate cut is in the offing. But the Fed may not be able to do anything about the economic weakness we’re seeing right now — and anyway, perhaps a recession is what America needs, to squeeze out the excesses and bring responsibility back to financial decision-making.

A recession would be painful for many people and institutions, so it’s not something to wish for. It’s increasingly unclear, however, whether we have any other path through.

Fortunately, web startups of today can get started with very little capital, reducing risk to themselves and to investors. Plus, dual-mode business schemes like the freemium model that seeks revenue from both advertising and subscription fees could offer a means towards financial success even when one income stream falters.

Hopes and hedge fund envy aside, the web startup and broader tech economy could be in for an uncomfortable ride, if last Friday’s job numbers accurately portray the trajectory of the broader economy.

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