Kedrosky: First the Warning, Now the Fallout

In ways, it feels silly, comparing an alarmist email about the market by Y Combinator’s Paul Graham to the 56-page slideshow produced by Sequoia Capital in October 2008.

While both were designed to warn their portfolio companies of tough sledding ahead, an email is no carefully conceived PowerPoint. And Graham’s email is a direct reaction to Facebook’s IPO, which has negatively impacted a very small circle of people; Sequoia Capital’s slideshow was a response to a deep global financial crisis precipitated by some of the most dramatic days that Wall Street has ever seen.

Still, instinct tells me Graham’s message will pack more of a punch than even he is willing to concede. (He told AllThingsD today, “I never thought anyone would care enough to treat this as news. The email is mostly fairly technical stuff about what to do if the funding market turns bad.”)

Economist Paul Kedrosky, who I caught up with a bit earlier over the phone, seems to agree with me. His reaction to Graham’s email, edited for length, follows:

Will there be an impact? There’s already been an impact.

There’s been this rapidly expanding bubble, in terms of people getting excited about this whole domain of social, and social media, and social media on mobile. And as hedge fund guy recently said to me, ‘Having Facebook s**t the bed’ [forces a lot of the air out of that bubble].

It’s causing a whole bunch of things to happen at once. First, people who were on the margin, those who were thinking of bringing new money to market in terms of funding startups, are now reconsidering. It doesn’t take much to [spook] them if they were at the margin. Then a bunch of people who were counting on pulling money out of Facebook, including secondary traders who might have cycled their capital back in to the market, have less money than they thought they would right now. More, they’re newly convinced that this marketplace is shakier than they’d thought.

And [these factors] matter immensely because in all markets, prices at are set at the margin, so when you wipe [out those investors], prices don’t come down by a little but by a lot.

As for what happens now:

[Facebook’s IPO performance] has shown people that this bubble is different, that the 1999 playbook won’t work in part because the early, high-profile IPOs that were supposed to be moon shots weren’t.

What Paul [Graham] was alluding to [in terms of the impact on startups] is: don’t become hung up on valuation, and take the money if you need it.

The reality is we’ll see an explosion in the number of companies that can’t raise money on any terms whatsoever, including a lot of companies that have come through one of these accelerators. In years past, the dead pool was comprised of companies that had [raised and burned through] $100 million in VC funding. The new dead pool will be filled with accelerator companies.

As for investors, prices are [soon] coming down dramatically. Marginal deals won’t get funded, and things that are fundable will get money at lower prices. Hot deals will continue to get done at high prices, because more and more money will be squeezing into fewer deals. People will be too nervous to invest [in anything else].

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