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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.

25 Responses to “Will Weakening Economy KO Web Startups?”

  1. Forecasting is never simple. Many variables must be considered. For technology start-ups to work, they need to generate revenues and find an exit. Exits tend to be a function of public market investors moving from one sector to another. I believe there is a strong relative case for technology IPOs. The tougher question may be whether or not venture-backed companies will be able to keep growing. The one point missed in this string is that we are in a global economy, where growing economies can help maintain demand for U.S. technology. I disagree that a U.S. consumer-led recession will automatically hurt technology spending. Disruptive technologies will still be able to deliver growth, whether to enterprises or consumers. Clearly, marginal start-ups will keep failing. The swing variable will be the reward for the winners.

  2. Anne:

    Thanks for your insightful post on the coming storm in technology money, which seems like a repeat of one that happened not even 10 years ago! Loaning money to bad credit risks never made sense in the past, doesn’t now, and won’t in the futue. I cross-posted on your piece, along with some comments of my own, at The Innovators Network is a non-profit dedicated to bringing technology to startups, small businesses, non-profits, venture capitalists and intellectual property experts. Please visit us and help grown our community!

    Best wishes for continued success,

    Anthony Kuhn
    Innovators Network

  3. If investors move back to tech, my concern would be the proliferation of garbage that we say before the dot-com bust. At least now, even though there are a lot of useless Web 2.0 startups out there, companies that do receive venture capital have a reasonable chance of succeeding. No matter what happens with the US economy, however, business models will adapt to suit their environment. It would probably be a blessing to see a move away from advertising-generated revenues.


  4. Pascal, there are different ways of measuring inflation, and some measures show fairly high recent inflation. Over the past few years, we’ve seen incredible home price inflation but that doesn’t show up in governmental measures of inflation because they use rent, not home purchase prices to calculate the inflation rate. Also, the core inflation rate strips out energy and food prices which have shown recent increases.

    As for an overextended corporate sector, we do see that in hedge funds and private equity. Just because it’s different actors that are overextended doesn’t make it benign.

    If there is a “consumer recession,” there will likely be an overall recession because the economy is interlinked. The fact that there is a secular shift from offline to online will soften the blow for companies with an online focus but it doesn’t remove the danger of a contraction that spreads to all parts of the economy.

  5. Recessions usually occur when inflation and an overextended corporate sector are in evidence. Neither of those conditions are present today in the U.S.– in fact, we are closer to deflation than inflation. When commenting on capital flows into Technology and Venture Capital, your initial comments appear to be narrower than Keith Benjamin’s observations– while some sectors in technology may not benefit from housing related contraction, others may not be impacted. The general point to consider is that most technology companies are unlevered growth vehicles. And even if there is a consumer recession, the underlying growth drivers for online media represent a secular shift from offline to online that has little to do with marginal growth and everything to do with a shift in business model.

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  7. It’s funny, talking about the threat of a recession even though the unemployment rate is still under 5%.

    Even so, recessions have gotten far less severe than they used to be, a result of the Fed having better information technologies…maybe we should thank the venture capital firms for that?

  8. working at a web company that already got our funding supply cut off as a direct result of the market troubles, I am willing to bet that it will hurt. In our market, video-on-the-web, and our company as a producer of content specifically, revenues from ads, etc. are so nascent as to not be enough to support us on their own…

    I will be surprised if we do not make major cuts in the next three weeks.

  9. Great post … sobering assessment. Since I’m with a web startup, I hope, as Keith Benjamin forecasts, that investors will find favor with tech. But my hope is also for the economy as a whole, for all of us, that we find clear skies as soon as possible. The U.S. economy has changed dramtatically over the past decade, proving resilient each time doomsayers predict financial armageddon. But it was foolish to think housing prices would rise at a 60 degree angle forever, and now that the slide keeps sliding, it’s foolish to think the economy isn’t in for one heck of a hangover after a years long binge.

  10. Nice blog post. It may sound counter intuitive but there are ways for people to make money even during recessions. And as you said, recessions may not always be a bad thing. And further indeed if one is clever, starting a web based business that proves useful to an audience (be they consumers or businesses) will always find a way. If the market desire exists, the market will pull the entrepreneurs plain and simple!