Who’s Afraid of the Big Bad Recession?

With yesterday’s 0.75% rate cut by the Federal Reserve, the press has been rightly focused on the ripple effects that the soft economy will have on the US and the world.  Amidst the high-level analytical fervor, the mainstream press has not probed on the implications to the venture capital/start-up economy, which fuels so much innovation, particularly here in Massachusetts.

There are two interesting competing forces at work.  First, venture capital investments are obviously negatively impacted by the down turn.  Start-ups that were funded during what will be seen as the “go go days” of 2005-2007 will struggle to maintain their growth and momentum through the economic head winds.  If VCs invested in these companies at inflated prices and, on the margin, over-capitalized these companies, their returns will suffer.

But on the flip side, looking prospectively at the VC asset class, one might argue that it is suddenly looking more appealing than ever, particularly on a relative basis (reminds me of the joke about the two “buddies” being chased by a bear realizing that they don’t have to outrun the bear, just one another).  Over the last five years, our later stage private equity cousins benefited tremendously from cheap debt, a rising stock market and a robust IPO market.  Spectacular buyouts could be executed with modest capital at risk relative to the total deal size and then flipped for a nice profit 2-3 years later.

As a result, limited partners began to pour a greater share of their “alternative” asset class dollars in private equity and holding their venture capital exposure relatively costant.  But with a choppy stock market and evaporating IPO environment, suddenly those easy buyout returns don’t look so easy any more, particularly given its dependency on the US banking system, which is the sector of the economy that appears hardest hit.

In contrast, the venture capital asset class is looking pretty good right now, with its 10 year window that in theory can skate through a few economic cycles and a sector exposure that’s more dependent on IT budgets (which appear to be remain reasonably robust, with IDC forecasting 6% growth in worldwide IT spend to $1.3 trillion in 2008) and the shift of marketing dollars to digital environments such as the Web and mobile (which appears inexorable, with Internet advertising forecasted to grow to $24 billion in 2008, almost a doubling from $14 billion in 2006).  It is interesting to note that on the same day that the Fed announced its rate cut, the Dow Jones announced a modest increase in 2007 of VC dollars invested of $30 billion (8% above 2006 across the same number of deals) and a nice balance of fund flows with $32 billion raised.

The last economic cycle demonstrated an interesting lesson for VCs – start-ups that were created during the 2001-2003 downturn have proven to be terrific investments 5-6 years later.  Incubating small companies during economic downturns, forcing managers to be prudent with their capital and quietly positioning themselves for strong growth and leadership when the market turns, is an age old start-up playbook for success.

My advice to entrepreneurs – don’t wallow in self-pity about the negative impact the economy will have on your 2008 performance.  Instead, this is a great time to hunker down, steal incremental market share and build a valuable company that will be poised to take advantage of the predictable upturn around the corner.