wsk: Venture Capital Financing Slows Amid Economic Downturn

"Silicon Valley technology startups are adopting a new business plan: deferral.
MerchantCircle Inc., a Los Altos, Calif., Internet startup, typifies the trend. Last month, company founder Ben Smith was in New York talking to media companies about raising $50 million, with which he planned to make acquisitions to fuel MerchantCircle's growth. But as the financial markets tumbled this month, Mr. Smith canceled two trips to New York and a roadshow to Europe to raise the capital. For now, the fundraising is on the backburner.
"When we started the year we were pushing really hard for growth," says Mr. Smith, who in 2005 founded MerchantCircle, which provides online advertising services for small businesses. "That's just not as important anymore. Now it's all about cash flow."
The shift is being echoed across Silicon Valley, where executives at startups—which form the foundation of the tech economy—are now deferring expansion projects, taking voluntary pay cuts, delaying hiring plans and slashing expenses. The shift is a turnabout for the region's young companies, which have traditionally focused on go-go growth by grabbing customers early and being first to market with new technologies.
The change is being spurred by the souring economy and market gyrations, which have hit startups' main source of funding: venture capital. Prominent Silicon Valley venture capital firms Sequoia Capital and Benchmark Capital recently sounded the alarm, saying a downturn would be protracted. Venture capitalists are now slowing their investments, doing just 583 deals totaling $7.37 billion in the third quarter, down from 673 deals totaling $7.94 billion a year ago, according to research firm VentureSource. VentureSource is owned by News Corp., which also publishes The Wall Street Journal."
"The pullback recalls the tech slump earlier this decade, when venture capital also froze up and numerous startups flopped. That downturn, which started in 2000 and lasted till 2004, helped weed out weak companies and taught surviving firms better fiscal discipline.
But it also led to the disappearance of one in five jobs in Silicon Valley. And it crimped innovation, as companies put off new projects. In several quarters in 2000 and 2001 as the tech bust took hold, there was a dip in economic productivity, according to Forrester Research.
The coming shake-out will "weed out the weak" but there are risks that some innovation will be stifled, says Eric O'Brien, a venture capitalist at Lightspeed Venture Partners. Earlier this decade, the tech bust made telecom firms wary of buying unproven communications technology, forcing an end to even promising tech start-ups, he notes. "My fear is that some of these companies may die when they shouldn't," Mr. O'Brien says.
Many startups are already suspending development projects this time, which could affect innovation. Ruckus Wireless Inc., a Sunnyvale, Calif., startup that makes wireless equipment, this month shut down research and development around potential new wireless products. While those projects were "nice," they weren't "material," says Selina Lo, Ruckus's chief executive, who adds that killing the projects would save the company $150,000.
Ruckus is partly funded by Sequoia Capital, which held a presentation for entrepreneurs earlier this month warning of the dire economy. Ms. Lo says the event "freaked people out," leading to her decision to eliminate new development. In addition, Ruckus's executives took a voluntary 10% pay cut mid-month "to demonstrate that everyone must share the pain for a more secure future," she says.
Such moves have implications for Silicon Valley's economy, which until recently was holding up. Silicon Valley's unemployment rate in September was 6.5%, for instance, far below California's overall unemployment rate of 7.5%, according to the state's Employment Development Department. Companies had continued to fight to recruit strong technical talent, over whom price wars had regularly broken out.
Now such employment-package inflation is likely over. Bill Nguyen, founder of music Web site Lala.com, says he had planned to grow his Palo Alto, Calif., company to 70 employees from 35 in September. But this month, he put hiring on hold. He now expects Lala to top out at about 40 employees by the end of the year.
"We have internal arguments daily about hiring," says Mr. Nguyen, who is trimming Lala's burn rate—Silicon Valley lingo for how much cash a young company with little revenues and no profits goes through each month—to $500,000 a month from more than $650,000 a month. "It's a choice between accelerating growth or taking a more conservative approach and lasting another three years."
Silicon Valley commercial real estate, which had been in the doldrums for much of this decade because of the tech slump, is also likely to take a fresh hit. Lala's Mr. Nguyen says he this month deferred taking on a new office lease that Lala had signed earlier this year. Meanwhile, Ruckus CEO Ms. Lo says that she has postponed adding 5,000 to 10,000 square feet in new construction to the company's offices.
Not all tech startups are deferring their plans. Internet chat startup Meebo Inc. raised $25 million in April, before the funding environment soured. Seth Sternberg, CEO of the Mountain View, Calif., company, says he remains on track to develop new services to grow revenue. The 45-person company is also still hiring and plans to get to 55 staffers by the end of the year."