Is the Startup Boom Masking Tech's Bigger Problems?

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The summer of 2010 is a heady time for Silicon Valley startups. Venture financing is on the rise: up 49 percent on year to $11.4 billion in the first six months of the year, according to the NVCA. Companies like Skype and Demand Media are venturing into the IPO queue. And law firm Fenwick & West said last week the average valuation of startups increased 30 percent in the second quarter. You don’t need to see the data to see how busy things are: Just visit an area where startups are sprouting like crazy, like San Francisco’s South of Market, and feel the energy for yourself.

Growth in tech areas like mobile and cloud computing has been a stark contrast from other areas of the U.S. economy, and there have been a number of unsettling signs in the last week or so that the economic recovery seen in those areas is more fragile than it may have appeared, and that fragility is being noted in many other areas of technology.

Less than two years after the market crashed and Sequoia hosted its legendary “RIP Good Times” presentation, corporate IT spending is slowing. Gartner warned Thursday that growth in IT budgets would be not be as strong as it initially expected, as companies hoard cash. Research shops like Gartner know that too many bearish forecasts aren’t good for business, so it buried the real bad news in a comment from Research Director Kenneth Brant near the bottom of the press release. Tech companies, Brant said,

“should act now to develop contingencies to mitigate the risk of zero growth in 2011, a scenario that carries a lower probability but a much-higher potential impact. The bottom line is that technology providers need to be prepared for the worst case, where commercial IT markets stagnate and governments transition to fiscal austerity programs.”

An even bigger reality check came from Cisco, which saw its stock drop more than 10 percent after CEO John Chambers said customers saw “softening” in their business in late June and early July and were adjusting their spending for the coming year to accommodate slower economic growth. “My customers began to share views of 2% GDP growth in the U.S.; they’re concerned about Europe,” Chambers said in a conference call. “When the customers get nervous I get nervous.

Chambers also cited customer concerns about a soft economy back in November 2007, a forecast that proved eerily prescient. This time, Chambers put the best face he could on the bad news, outlining Cisco’s intent to keep hiring and stressing that the customer caution was centered around the European debt concerns in June. But if concerns have eased slightly in Europe, they’re rising in China, where the economy is also cooling, and in the U.S., where a top official at the Federal Reserve spoke explicitly about deflation and Japan-like 15-year recessions.

Last week also brought evidence that slower consumer spending is also starting to take a toll on tech. Graphics chipmaker Nvidia said consumers are foregoing high-end graphics when buying PCs, and that’s when they are buying a new PC at all. A J.P. Morgan analyst issued a note warning that PC orders are “falling off a cliff.” Meanwhile, market research firm NPD Group weighed in to say video game revenue was down 1 percent in July from a year ago, and gaming software sales were down 8 percent.

As we saw when the recession hit, throwing around phrases like caution and uncertainty — let alone worst-case scenarios — can create an echo chamber in which these attitudes reinforce each other. Hearing that others are spending less makes you more cautious yourself, whether you’re a company or a consumer. As we also saw, even the hotter areas of tech aren’t really immune once the spending slows down enough.

It’s true that the mobile web and cloud computing are young markets with a lot of growth ahead. But many of the companies using the services or buying ads to support revenue are returning to a cautious mindset as they see uncertainty ahead.

That caution is a reminder of what Sequoia partner Eric Upin said in the RIP Good Times presentation nearly two years ago: We could be entering a 15-year secular bear market. If so, we’re only looking at year three. It doesn’t mean the growth will necessarily slow dramatically across the board, but it does suggest smart managers should be planning to react if growth slows considerably.

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