Posted on March 11, 2008
Filed Under Dramanomics |
As the United States economy tanks, I’ve noticed quite a bit of arrogance amongst Silicon Valley types who are “This isn’t our bubble.” Many have expressed a sentiment that the serious problems in the greater market would not spill over into the Valley economy. VCs raised nearly $35 billion last year in a show of confidence.
But anybody with common sense knew that such confidence was foolish. Silicon Valley’s economy is part of an “open” platform called the United States economy - it’s not a “walled garden.”
Startups and the VCs who are backing them are apparently starting to learn this the hard way. Michael Arrington at TechCrunch is reporting that “up to 20% of venture backed startups may have been convinced by their financial advisors to put much of their spare cash into something called Auction Rate Securities, on the promise of money market-like liquidity with better returns.”
Last month, auction rate securities became the latest victim in the credit market clusterfuck. 258 auctions in the $330 billion ARS market failed on February 13 alone. In comparison, only 44 auctions failed between 1984 and the end of 2007.
ARS’s are typically sold to “sophisticated” investors and corporations. Some are being hit hard. Business airline JetBlue reportedly has 72% of its cash and investment securities tied up in ARS’s and pharmaceutical major Bristol-Myers Squibb on failed auctions.
Apparently a non-negligible number of VC-backed startups were convinced that ARS’s were an attractive alternative to money-market funds because of the higher interest rates despite the fact that some advisors, such as SVB Asset Management, had been warning clients about the risks posed by ARS’s :
Our principle concern is the liquidity in the auction process. A lack of interest in this security type increases the risk of a failed auction, which could result in the accounting reclassification of the bonds as long-term rather the “cash-equivalent” status used by many investors today. At that point, investors would be left with a 20 to 30 year bond position with an unattractive coupon. We recommend that risk-averse investors avoid these securities at this time.
One of Arrington’s VC contacts “believes 5-10% of total invested cash is frozen.” Some VCs apparently did not know that their portfolio companies were using ARS’s while others have admitted “We just had no idea this was even a risk at all.” In both cases, the notion that VCs effectively serve as knowledgeable, trusted advisors and partners is dented.
The situation is apparently pretty bleak for a number of startups who are experiencing cash flow problems and are running around trying to find access to money. Some of the VCs behind these companies are reportedly leaving them to fend for themselves, highlighting not only the fact that VCs are never your friends when things turn sour but also the fact that VCs are probably (wisely) recognizing that they funded startups that aren’t worth saving anyway.
Of course, the big take-aways from this mess are:
- The biggest financial crisis in decades will impact Silicon Valley. When the word “stagflation” starts getting bandied about, everybody is affected.
- While all companies, including startups, typically park some money in money-market funds, etc., the fact that quite a few seemed compelled to put money into ARS’s demonstrates a disturbing dynamic. Given that VCs fund startups so that they can build successful businesses, startups should be more concerned about putting the capital raised to good use than they should be in squeezing out the best returns from where they stash that capital. As VC Fred Wilson noted in a discussion of his firm’s experience with ARS’s, “we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year.” Startups committed to building a business and paying their bills should have taken a similar approach.
- If startups are running into cashflow problems that are exacerbated by failed ARS auctions, it still means they would likely have had cashflow problems anyway and sooner rather than later. If we assume that the average startup with exposure to the ARS market didn’t put an ungodly percentage of their capital into the market, any cashflow problem signifies that the company was in trouble to begin with. As noted by one TechCrunch commenter, “A startup without a steady flow of cash, is like a car without oil…it can’t run.” And as noted by another, “A far more interesting question is why are these startups trying to get at their ’spare cash’. It sounds like this may be the least of their worries.”
It will be interesting (and possibly amusing) to watch this play out. Whether this mess speeds up the inevitable busting of the Web 2.0 bubble remains to be seen, but at least some of the smugness in the Silicon Valley community will deflate as entrepreneurs and investors scramble to find cash.
Perhaps I should expand my loan shark operation to Palo Alto. Sand Hill Shark has a nice ring to it now that I think about it.
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