Why the startup market is like the real estate market

March 25, 2008

Homeowners hate to sell their houses for less than they paid for them. When prices fall, instead of adjusting to the new reality, homeowners keep their price expectations hoping that their house will sell. In the short run, they don’t need the money and patiently sit on the house. As a result liquidity dries up in the market. After many months, they adjust their price expectations and the market begins to clear again.

The same thing is about to happen in the startup world. In theory, startups should be insulated from the current macroeconomic headwinds. The current economic slowdown is caused by massive deleveraging around the economy. Venture capitalists are not funded by debt and cannot afford to sit on all the capital they raised for too long. Likewise, startups for the most part have no debt. However, as public valuations of consumer Internet companies have come down by over 25% across the board (and in some cases much more than that) and the IPO market has shut down, exit multiples are likely to decrease accordingly. Moreover, VCs, like most people, are like sheep. If everyone is putting their heads down and bracing for the worse, they will do the same and be much more careful.

Because there are still a few crazy deals happening, like Slide raising money at a $500 million valuation or Bebo being acquired by AOL for $850 million (a good sign we are at the top of the market), startup owners have not yet realized that this will affect them. Valuations are about to come down, but like homeowners, startup owners take a while to adjust to the new reality. Few deals will get funded for 12 months. Eventually the need for cash will win and deals will start happening at much lower prices. In fact, valuations might fall by more than they “should” if you have hundreds of deals that have to get funded simultaneously coming to the market.

People with cash will be in a much stronger position in 12 months than those without and should be able to buy companies and advertising at much lower prices.

Conclusion: Your greed versus fear dial should be turned to the fear side right now. Raise money now (even if not at the valuation you dreamed of) and be extremely careful with your cash burn.

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