As a professor of entrepreneurship, I teach about 1,800 to 1,900 students a year. That creates a seemingly neverending stream of students coming to my office to pitch an idea or simply to ask for advice. Recently, many of these student entrepreneurs and others from our community have been coming to me asking how they should finance their startups and what kind of financing they should pursue. The answer depends on what’s going on in the general economy as well as developments in the financial marketplace.
- What have been the recent implications of the economy and market performance on financing startups?
The domestic U.S. economy, while generally appearing to be not particularly bad, has some imponderables. First, banks took a major hit several years ago, and they are still feeling the effects by way of increased regulation. In fact, it was a double-barrel hit. Fannie and Freddie stopped purchasing mortgage-backed securities from the banks, and then the feds stepped in and forced banks to clean up their balance sheets. At the time, many banks had a significant quantity of both commercial and residential real estate paper on their books that was categorized as either under-performing or non-performing. Of course, they were forced to write these assets down. Some banks disappeared. Others had their capital positions severely impacted, which put pressure on both their ability and their appetite to extend credit. Second, the recent devaluation of the Chinese yuan coupled with the precipitous slowdown in the Chinese economy has rippled through the capital markets worldwide. I recently asked the chief economist of an international bank for an opinion on the extent to which China will affect world economies and how long the Chinese slowdown will last. Her answer: “I don’t know.”
The point I’m making here, the imponderable I referred to above, is that there is significant uncertainty out there and it is affecting both our economy and our capital markets.
Given this uncertainty, investors, both institutional and angel, have limited their investments in startups. The result has been that some potential startups have not started up because they have not been able to secure financing. Another group, while they have secured some financing, started up undercapitalized, forcing them into immediate cash flow problems. These firms have either given up or are struggling to try to resolve what essentially is an unsolvable problem. A third group has received what I call anemic financing. This latter group has launched, and may even be growing, but is doing so at a slow pace that will affect their ultimate scale. This generally has not been a good situation.
- What changes appear on the horizon for investors and startups?
There are three, as I see it. First, “lean startups” entail business teams that are exploiting opportunities involving cloud computing, Web 2.0, and web apps, and thus, they do not need millions in venture capital. They can essentially create a very scalable software-based business requiring no more than a few hundred thousand dollars. They are not trying to establish infrastructure that has traditionally run up the price of launching an enterprise. Many are even virtual. With less deal availability involving strong, investible enterprises seeking $5 million to $10 million, I’ve observed two developments in the venture capital space. First, VCs are having a more difficult time deploying their funds, and a lot of “dry powder” is on the sidelines. Consequently, their average individual investment size appears to be declining. Over time, this would suggest a more difficult time managing their portfolios. Second, some VCs have created small funds within their larger organizations to participate in this “lean startup” trend. An example I’d cite is the iFund created within Kleiner Perkins to invest in firms creating businesses based on iPhone apps. Ultimately, this suggests that VCs may scale down investments and begin to move into what has traditionally been the realm of angel investors. This could begin to muscle out angels, which would be very unfortunate as angels in total have typically invested about twice the amount as have VCs.
Second, and this is really quite interesting, because of the amazing volatility in the markets due to what is generally perceived as no more than emotion, angels have begun to feel that private equity investments are more secure than traditional investments in early stage or established companies. One reason they feel this way is that they have an opportunity to exercise some control in their private equity investments by getting involved to help. I find this both very interesting and very non-intuitive.
Third, there has been the emergence of what are called “family offices.” Families of substance have begun to create their own early stage investment funds and hire professionals to manage those funds. The professional managers typically are incentivized based upon returns at liquidity events. These funds are willing to invest smaller amounts than VCs and are willing to wait longer for liquidity events.
- So, what does this mean for startups? Where should they look for financing?
Given what I’ve indicated here, I’d say that pursuing angel investment would be the highest leverage use of most business teams’ time, assuming that significant financing isn’t currently required. I’d continue in parallel to try to forge relationships with a few family offices and VCs but not with the intent of securing investment from them currently. Allow them to become aware of and interested in the enterprise so that they can be targeted later for expansion capital.
BILL ROSSI has been a faculty member in the Warrington College of Business Administration at UF since 2001. He is a master lecturer in entrepreneurship, the Wells Fargo Faculty Fellow in the business school and the associate director of the Center for Entrepreneurship and Innovation. Bill teaches several courses, including Principles of Entrepreneurship, Graduate Entrepreneurship, Business Plan Formation, Venture Finance, Venture Analysis and Creativity. He has won numerous teaching awards at UF. Before beginning to teach in 2001, he had extensive experience in finance, general business, sales, and operations management, and he has held several senior level positions with Fortune 500 companies. After relocating to Florida in 1986, Bill worked in executive management positions in smaller, entrepreneurial companies and has been a principal in several. William J. Rossi, Clinical Professor of Entrepreneurship Associate Director, Center for Entrepreneurship and Innovation, Wells Fargo Faculty Fellow University of Florida