Unstable market could cut the flow of venture capital to start-ups

For investors in start-ups, the fear of getting burned might soon trump the fear of missing out.

Venture capitalists, mutual funds and wealthy individuals for several years have paid increasingly higher prices for shares of privately held technology companies, seduced by a 6-year-old stock market rally that seemed to promise future profits.

But with stock markets around the world looking ugly after a plunge that began Aug. 20, some start-up investors are doing double takes. U.S. markets, including tech stocks, rallied Wednesday but only after five consecutive days of triple-digit losses.

Sustained declines, or even volatility, could pose trouble for young tech companies that depend on fresh injections of capital. Fall is usually a busy season for IPO filings, but an unstable market will probably mean delays, experts said.

"Periods like this are pretty much your worst nightmares," said Sam Hamadeh, chief executive of private-company tracker PrivCo. "There are literally meetings across Wall Street, where road show schedules were being planned, that are now about thinking, 'Can we get late-stage [venture] funding to raise capital?'"

Private investors won't be rushing to sign new deals until the markets' direction becomes clearer, which will take at least several weeks, said Eric Liaw, a partner at Institutional Venture Partners, an investor in Southland companies Snapchat Inc. and Honest Co.

"If broadly speaking, public investors are resetting valuations, then the private market has to follow," he said.

Venture capital investment in the U.S. took a big hit after the financial crisis, plummeting more than a third to $20.3 billion in 2009 from $32 billion in 2007.

By 2014, though, it had reached $50 billion, according to the National Venture Capital Assn.

Based on the first two quarters this year, it was looking as if 2015 would be even better. But that was before China devalued its currency and the stock market slid.

If the stock swoon turns into a prolonged slump, start-ups would be forced to reduce their own value the next time they seek private capital. Prices for initial public offerings, a traditional route for investors to cash out, could dive too.

Start-up employees who hold stock grants would see a less rosy future — even if they stuck around after a demoralizing valuation drop.

"The new fear is you're going to have a lot of companies valued ahead of what they can get on the public market," said Mark Terbeek of Greycroft Partners' Los Angeles office. Heavy-spending start-ups that have set high prices for their shares "will be most vulnerable."

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It's hard for outsiders to gauge expenses at start-ups, which generally keep such figures private, but companies such as Dropbox and Pinterest are among those that some valuation experts say are priced high given their revenue performance so far.

"The day of reckoning," as Terbeek called it, is probably far off for companies such as Uber and Snapchat, whose bank accounts are stuffed with venture capitalists' cash. They have flexibility to adjust business plans in an economic downturn, and investors are bullish on their prospects, allowing for more private funds to be raised at stable prices.

But even that could change fast if mutual funds such as T. Rowe Price stop writing huge checks in an extended downturn. Venture capitalists suspect that these funds, new to such investing, would do just that. T. Rowe Price declined to comment.

In the long term, a down market could see wealthy individuals who provide seed money to start-ups in their earliest days scale back, and the big venture capital firms would eventually follow suit.

Funding from venture capital firms should hold steady because they have raised record amounts from foundations, pension funds and other institutions. Whether the investors re-up at similar levels when the funds need replenishing will depend on benchmark interest rates and the performance of bond and real estate markets, experts said.

It's been a bull market for start-ups for a while. More than $125 billion has been invested in start-ups over the last three years, according to the National Venture Capital Assn.

If the market keeps declining, companies that have quickly spent initial investments will feel the most pain. Such corners of the start-up world include app companies that provide services such as assistants and food with a tap of a smartphone. The start-up tracking firm CB Insights recently identified 12 on-demand food delivery companies, some of which have launched in several cities, that "might be at risk of overextending themselves in the race to gain market share in the top metros."

Some veteran start-up chief executives said they already shifted into conservative mode to prepare for a market swoon.

Bob Wiederhold, who's run several small companies in the last 25 years, said his database software start-up Couchbase restrained spending compared with competitors because experience taught him that easy access to capital is temporary.

Couchbase raised $115 million from 2009 through last summer. Most of that remains in the bank. Wiederhold said he's only slowly expanded outside North America and Europe, and has avoided spending lavishly on "palatial" offices or developing features that might stretch the company too thin. Couchbase, based in Mountain View, sells its product to Nike, EBay, Wells Fargo Bank and other companies developing online applications.

"We feel confident that whatever occurs in terms of valuations and funding, we can see it through," Wiederhold said.

Ranjith Kumaran, chief executive of file-sharing service Hightail Inc., took several steps to rein in costs at the Campbell, Calif., start-up last September. He noticed investors were discounting shares of start-ups in his industry.

Box, one of his competitors, struggled to launch an initial public offering. Bigger, more well-financed companies, such as Microsoft Corp., made similar data storage services more affordable. And potential buyers offered prices Kumaran found unattractive.

Time to change strategies, he told himself. He shut down Hightail's four international sales offices and canceled partnerships that didn't generate revenue. He re-focused the company on a new app aimed at helping ad agencies, design firms and other "creatives" manage and collaborate on projects.

Since then, Hightail has held at about 90 employees and started bringing in more cash than it was spending. That meant no need for now to supplement the $94 million it received from private investors, the last of which came two years ago.

"Everyone's excited about user growth and fundraising, but the end goal has to be revenue to let a company grow on its own," Kumaran said. "Sometimes the battle is won by being the lone survivor in these downturns."

Terbeek, the investor of several digital media companies, noted that the recent swings in the U.S. stock markets reveal the uncertainty.

"Is this a fundamental change or just a nervous day?" he said.

paresh.dave@latimes.com

Twitter: @peard33

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