Credit Freeze Puts A Chill On Startup Companies

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The prospect of a prolonged economic downturn has hit businesses hard, but the frozen capital markets have had a particularly chilling effect on startups — and the investors that fund them.

In a normal year, legions of entrepreneurs get funding from private investors who like their concept. It's called venture capitalism. The idea is for a young company to incubate and grow on this private money for a few years. If the concept works, it all pays off when the company is sold.

But if there's no buyer, there's no payoff.

The president of the National Venture Capital Association, Mark Heesen, says when that happens, the company just sits.

"Just like you have a teenager that you thought would be out of the house by now, we have companies that we thought we would have sold or have gone public by now and they're still at home," Heesen says.

During the first three quarters of 2008, the association says only six venture-backed companies sold shares to the public through initial public offerings. That compares with 86 IPOs in 2007.

"We saw zero IPOs in the second quarter of 2008," Heesen says. "That's the first time in the 30 years that we've been tracking this that we've never had an IPO in a quarter."

One of those shelved sales was a company called Convio, which designs software that helps nonprofits track and communicate with donors. Convio had hoped to sell shares to the public earlier this year. But when it came time to pull the trigger, Chief Financial Officer Jim Offerdahl says, there simply was no interest from investors.

"We decided that good companies don't go public in bad markets," Offerdahl says. Convio scrapped its IPO plans in August.

If the scenario continues, venture capitalists face the prospect of having to fund companies for longer before cashing in.

Trevor Loy, managing partner for Flywheel Ventures in Santa Fe, N.M., says this is starting to happen to his company. Flywheel has $40 million invested in 23 companies.

In order for his fund to keep investing in new ventures, he needs his current companies to find their own money source. And in order for that to happen, the stock market and the economy need to recover.

This is because, historically, it's the private investors who've been willing to take risks on new technologies, Loy says. He notes that bigger, more established companies tend not to fund revolutionary ideas. Companies such as Google and Apple and many companies in biotech and "green technology" started out with seed capital from private firms.

"Whether it's climate change or environmental sustainability, or human health and disease, or the need to build infrastructure for 3 billion people who are joining the middle class around the world — those are all challenges whose only solution involve hard core, deep innovation," Loy says. "And venture capital has had a pretty outsized role in fueling that innovation in the last few decades."

For now, young companies with great ideas might survive with funding from existing investors. But for entrepreneurs looking for cash, a protracted downturn means having to cast their nets wider or just running on fumes for a while.

Do Recessions Stimulate Or Stymie Innovation?

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Believers point to inventors, such as Thomas Edison and Steve Jobs, and argue that a recession — a time of great change — is just the time to invest in innovation.

However, doubters point out that companies and investors feel the need to play it safe in tough times, tying up cash that funds tinkering.


Paul Maeder, founder and general partner at Highland Capital, a venture capital firm

Jerry Beilinson, deputy editor of Popular Mechanics



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