Sunday, October 26, 2008

Startups in the down economy and venture financing

I've recently read an article by Paul Graham about starting a company in bad economy (http://www.paulgraham.com/badeconomy.html). The gist of his position is that founders and the business idea are far more relevant to startup's success than sources of finances, and that a lot of formidable companies (Apple, Microsoft) were founded where when the economy was not exactly booming.

His position is logical of course, but it is interesting to note that a sound startup that is cash-positive on day one, or early enough, does not require venture capital. Neither Apple, not Microsoft had VCs as their shareholders when they went public, and the founders still owned vast majority of stock on IPO - something that happens very rarely today. I suspect - although I did not check - that the same is true for Sun, Oracle, Intel, SAP, and most other companies of the pre-dot-com generation.

And of course most of the crap VCs bring to market these days is companies without a revenue model (with the business based on attracting the eyeballs, not dollars), and they get sold either to the unsuspecting public, or a different company (i.e. the greater fool) before they make their first dime. No matter - one could always count that the greater fool would be found, and separated from their money.

The more entertaining read, however, was not the Graham's article itself, but the reaction it caused in the Silicon Valley "businessmen" (http://uncov.com/paul-graham-shut-your-face).

I was surprised by the level of vitriol, before realizing that the world of the 20-something founders must be crumbling: indeed, the immediate future is probably going to be tough for Intels and Microsofts of the world, but for the "eyeballs"-centered world of the Facebook apps vendors it will be nothing short of a mass extinction event.

People keep paying for the tools through the recessions, but the marketing budget - and with it, the Facebook ad revenue - gets cut first. Watch Google earnings for the next couple of quarters...

Anyway, Graham's post and the reactions to it are things of the not so distant past. The reason I remembered them was because today I read another article, this time by Thomas Friedman (http://www.nytimes.com/2008/10/26/opinion/26friedman.html), in which he argues for the government to play passive role in the banks in which it takes ownership. The question he poses is - would a government official give Larry and Sergey a loan to found Google.

As he often is on economic issues, Friedman is full of it. The whole reason we're having a crisis is because the banks that are part of the country's monetary system are also engaged in extremely risky speculative activities. Such as venture financing, derivatives trading, and so on. Specifically - because they are currently lending money to Larry and Sergey.

This was not always the case - before 1999 banks could not do any of these high risk activities, but it meant that the depositors' money - and the country's monetary system - were safe. Venture financing, complex financial instruments, insurance were handled by organization that had these functions - not banking - in their charter. All VCs could go out of business simultaneously, and nobody - outside the startup world - would have noticed.

Incidentally, this regulation framework was introduced during the Great Depression, as a reaction to activities that caused banks to fail during that era.

Gramm-Leach-Bliley Act of 1999 - heavily lobbied for by Greenspan, and written by McCain's former economic advisor - allowed banks to enter the businesses that were previously verbotten. As a side effect, it poured a lot of money into the .COM startup market, and later into the subprime mortgages, and thus precipitated the current collapse.

So of course government officials should not be deciding whether to lend money to a young startup - because a bank should never be lending money to uncollateralized ventures in the first place. This is the business of a venture financing firm, an angel investor, the founders themselves, but not a bank.

A bank should be - and for the most part of the recent history it was - an extension of Fed, and of course it is perfectly reasonable for a government official to sit on something so close to Fed and make decisions that impact the country's monetary system!

4 comments:

Nick said...

I'm not sure, but Fed exists for less than 100 years, while banks exist for a much longer time.
Offtopic:
please post more on technology and less on politics.

Thank you

dzembu said...

PG idea is mainly right:

The time to ACT is NOW! :-)

How to Act and if you should drop your day job and try to do a stupid .com : I do not think he said that :-) ( safely )

But be Smart and Act now ( do not wait till you get old and die :-) ) if what you want to do is Act :-)

Anonymous said...

Both Apple and Microsoft had VCs. Apple's was Sequoia, and Microsoft's was August.

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