The question many of us at the Kauffman Foundation are getting is this: "How are startups handling the financial crisis?"
The answer is that startups are probably facing tough times. In terms of financing, both ends of the venture lifecycle are dire: entry and exit. Exits are practically dead, because both the IPO market and acquisition opportunities are inactive. And liquidity events are essential to the entry of venture capital, which leads one to explore the status of startup entry financing. Most of the early stage investors we talk to are much more cautious -- deals are fewer and smaller. And bank loans are tougher to get and more expensive.
As Arnold Kling says,
If you invest in startups, your exit comes either from going public or being acquired, neither of which looks very likely with stock prices in the toilet. To the extent that there is any venture funding going on at all right now, the assumption must be that in two or there years the market will come back. I hope the market does come back, but efficient markets theory says that the best guess about where it will be three years from now is where it is now, plus a few percent. Venture funding is a whole lot riskier today than it appeared to be a month ago.
But how important is formal funding for innovation? Some new research by my colleague Alicia Robb indicates it is much more important than conventional wisdom suggests. I am from the "Bootstrap School of Entrepreneurial Thought," so am skeptical of the importance of formal funding, but I am eager to share Alicia's research as soon as it becomes available. I tend to believe that invention will continue apace, perhaps even accelerate, among inventors whether they are in basements or in cushy office parks. At a minimum, the recession of 2009 will be a perfect real-world test of the relationship between innovation and venture finance.
From a finance perspective, the venture industry is bound to face another shake-out, and may even experiece an existential turning point. The business model that relies entirely on liquidity events is inherently unstable (boom and bust). But there are value venture investors which have focused on companies that can build positive cash flow and long-term profitability regardless of exit. Those firms and the startups they back are going to shine in the next couple of years.