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How the Economic Rollercoaster Strains Startups

Tuesday, August 16, 2011
Posted by Ray Leach

The debt ceiling debate is over for the time being, but it sure doesn't feel like it. President Obama, the House and the Senate agreed on a compromise that increases the debt ceiling by as much as $2.4 trillion dollars. On top of the $900 billion spending cut over the next ten years from federal programs, agencies and day-to-day expenditures, the agreement called for the formation of a special "super committee" that must identify further spending cuts by Thanksgiving. If this committee deadlocks or if Congress reject the committee's recommendations, automatic across-the-board spending cuts of at least $1.2 trillion will go into effect.

 

Though the debt compromise is considered by most as sub-optimal, the alternative would have led to a U.S. default. Given the painful things that have already happened in the markets, who knows how much greater the pain would have been if, over the last week, we instead were watching the U.S. Treasury determine who would and would not get paid. In that scenario, I think we could have faced a downturn and volatility in the markets that exceeded 2008 and rivaled 1929. All this market turmoil does nothing to help entrepreneurs, particularly for ones seeking access to capital and other financial resources.

 

A poorly performing stock market, in addition to the anticipated public-sector budget cuts, put a damper on almost everything that high growth entrepreneurs need to be successful, including public and private sector resources for groundbreaking research and commercialization of disruptive, market-creating innovations. These macroeconomic issues also affect an entrepreneurial firm's ability to secure new customers who are willing to give them an opportunity to validate their innovations and technologies.

 

Downturns in public equity markets affect the private sector's ability to support entrepreneurs in a huge way. First, it has a significant influence over the amount of money venture capitalists can raise to invest in startups. Pension plans, endowments, foundations, and other institutional investors typically have a formal approach to their allocations across stocks, bonds, and alternative investments, which include venture capital funds. When the stock market declines significantly, the value of the equity investments owned by these groups declines more aggressively than the other financial assets in their portfolio that are not priced on a minute by-minute basis. As a result of the reduced value of these equity investments, many large investors end up being over-allocated in alternative assets like venture capital.

 

In efforts to rebalance their portfolios, large investors might reduce their new capital commitments to venture capital funds until public equity securities rebound on their valuations. We saw this happen in 2009. The number of venture funds that were able to raise capital decreased 30 percent and the amount those funds raised declined 38 percent. Right now, according to Mark Suster, an entrepreneur-turned-VC, investors are taking a wait-and-see approach and most likely won't invest until some stability arises. Similarly, the portfolios of individual angel investors are negatively impacted when the stock market takes a massive hit, leading them to shy away from risky investments in young entrepreneurial companies.

 

A public equity market facing steep declines also deters young, private venture-backed companies that would like to go public from doing so. They're fearful that they will not be able to raise the necessary funds from the public investors that startups require in order to go through the hardships of going public. This paradigm played out in 2008, when the number of venture-backed companies that went public declined 93 percent from 2007 -- from 86 to just six. Without these initial public offerings (IPOs), new investments in high potential companies and fundraising by venture capital funds tends to slow down until the pipeline of companies waiting to go public is cleared.

 

And finally, in this non-exhaustive list of what could happen, every economic downturn leads to a reduction in consumer and business spending, translating to lower demand for entrepreneurs' innovative products and services. From 2008 to 2009, for instance, business spending on technology declined 8.2 percent and consumers spending declined 2.8 percent.

 

On top of the market-related issues that impact the growth of young, high potential companies, government cuts and taxes are looming. That means entrepreneurs shouldn't be surprised to see slashes to the $2 billion Small Business Innovation Research program that funds startup R&D and product development. And as the government looks to cut costs, it will likely offer fewer or less attractive federal contracts, which can be a big source of revenue for young companies.

 

The public and private sectors are, to some extent, broken. Neither the government nor America's business and consumer masses can support entrepreneurship and change the trajectory of our economy alone. Because of this, we need to focus on creating partnerships between the public, private and philanthropic and institutional entities. When pooled together, these groups have more resources to support higher levels of entrepreneurship and innovation, which is so vital to our nation's economic revitalization.

 

Ohio has had some success in the area of partnerships. At the core of Ohio's commitment to innovation and entrepreneurship is Ohio Third Frontier, a State-led, public, private, philanthropic and institutional effort that will provide over $1.7 billion to R&D, technology commercialization, and entrepreneurial support. Even as the federal government considers cuts to every state in the country, Ohio has already made its long-term investment to support entrepreneurs and has ensured that changes in the economic environment cannot affect its investment. Ohio Governor John Kasich has demonstrated a determination to continue supporting entrepreneurship in the face of budget cuts. Amidst billions in spending cuts, he increased funding to programs that accelerate the growth of high potential companies.

 

Ohio isn't the only state using the partnership approach. In 2008, the state of Michigan created the Invest! Michigan, a fund capitalized with $300 million from the state's pension funds and funds from other institutional investors. The goal is to develop Michigan's entrepreneurial ecosystem. Other states have created similar initiatives to that of Invest! Michigan, including New York, California, Indiana, and North Carolina.

 

Collaborations across the public, private, institutional and philanthropic sectors mitigate the impact that market downturns and budget cuts can have on entrepreneurs and the investors supplying the capital they need. These partnerships, which lead to a sharing of resources, are essential to accelerating innovative companies and the growth of our nation's economy.

 

President Obama understood this imperative and launched the Startup America initiative earlier this year in order to create partnerships across the nation to accelerate regional entrepreneurial initiatives focused on high impact startups. This work is more important than ever, as the nation finds itself in a time when no single sector -- public, private, institutional or philanthropic -- can bear the load alone.

 

This blog was originally written for Huffington Post

 

Ray Leach is CEO of JumpStart and brings his energy and leadership experiences from founding five high growth entrepreneurial and intrapreneurial endeavors in the last 20 years. Ray is a Sloan Fellow and earned an MBA from the MIT Sloan School of Management. He also earned a BA in Finance from the University of Akron.

Categories: Big-Ideas-in-Economic-Development
Tags: equity investmentgovernment debtJumpStartRay Leachventure capital funds

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