Economy Putting a Drag on Silicon Valley

During the first three months of the year, only five companies backed by venture capital investors went public on Wall Street, the National Venture Capital Association said last week. That is down from 31 in the fourth quarter of last year, and is roughly the same level as at the nadir of the dot-com bust.

Housing prices in Silicon Valley remain defiantly high. New BMWs and Saabs cruise Highway 101. But for the first time there are signs that the current economic downturn is taking its toll on the country’s cradle of technology and innovation.

Job growth has slowed, start-up companies are hiring and spending more cautiously, and early-stage investors who nurture the start-ups with money and expertise are growing more frugal.

Most of the investors, entrepreneurs and innovators who build companies in the Valley do so with the hope of taking them public or selling them — the rainmaking opportunities that people here call exits. But with gloom pervading the financial markets and the business climate, the exits are hard to find.

During the first three months of the year, only five companies backed by venture capital investors went public on Wall Street, the National Venture Capital Association said last week. That is down from 31 in the fourth quarter of last year, and is roughly the same level as at the nadir of the dot-com bust.

There was also a sharp falloff in the acquisition of start-up companies by bigger corporations. Microsoft is making noise with its effort to take over Yahoo, but elsewhere things are quieting down. There were only 56 acquisitions in the first three months of the year, down from 83 in the fourth quarter.

With those options increasingly off the table, investors must spend money and time nurturing — or altogether salvaging — existing companies rather than building new ones.

“We are holding expenses very tight,” said Jim Breyer, managing partner at Accel Partners, a venture capital firm. The firm is an investor in Model N, a software company that recently withdrew its registration to go public because of the inhospitable market conditions. Mr. Breyer said the company would wait until the fall, at the earliest, to try again.

“It’s anybody’s guess how long the downturn will last,” Mr. Breyer said.

If it lasts through this year, he said, “it will be far more than an inconvenience for all companies.” The dried-up market for public offerings and acquisitions is affecting not just the atmosphere of innovation but also the lifestyle of its participants.

“Less cash coming into the Valley means less cash to purchase homes, and go out to nice dinners, spend on consumer products and go on vacations,” said Hans Swildens, founder and principal of Industry Ventures, an investment firm that buys stakes in start-up companies that need infusions of cash.

“The general sentiment in Silicon Valley is that we’re not yet there, but the reality is that we are,” Mr. Swildens said. “It’s already started.”

The region feels as if it is on the cusp of a mood shift. On the one hand, its denizens say they feel fortunate to be working in a segment of the economy and living in a region that has been hurt far less than other parts of the country. They also express stubborn confidence in the inexorable shift to the Internet and the role that Valley technology companies will play in that transition.

And they assert that they are not feeling anything like the pain that followed the collapse of the dot-com bubble, which led to big job losses, an exodus of talent, a plunging commercial real estate market and a significant drop in investment in start-up companies.

But having assiduously clawed its way back from the dot-com bust, the Valley is again facing some tough conditions. At the area’s blue chip companies, stock performance has turned grim as growth has slowed. Google’s stock has fallen around 31 percent this year; Apple is down 21 percent. The Nasdaq composite, an index with a major technology focus, is down 11.4 percent this year.

Among the shares of venture-backed companies that went public in the last year, only 28 percent are above the offering price. That compares with around 50 percent in a typical year and 70 percent in strong market conditions, according to the National Venture Capital Association.

New companies are hitting roadblocks on their way to the capital markets. Upek, a company in Emeryville, Calif., that makes computer chips and software used for fingerprint recognition, registered to go public last May. It then began trying to drum up investor enthusiasm, and was making progress. But on March 4, it withdrew its registration.

On Wall Street “there was suddenly no more appetite for growth companies,” said Eric Buatois, a general partner in Sofinnova Ventures, an early-stage investment firm that backed the start-up.

Upek is profitable already, but without the cash infusion from the offering, Mr. Buatois said, it will delay new products, limit the number of projects it takes on and hire less aggressively.

“You shrink your expansion plans,” Mr. Buatois said.

Upek has 30 employees in California and another 80 or so worldwide; it has manufacturing in Singapore, hardware development in Italy and software development in Prague. It also does 80 percent of its sales overseas.

Upek’s global nature, which is shared by a growing number of start-ups in Silicon Valley, is cutting both ways in the economic downturn. On the positive side, the overseas sales are insulating the company from some of the tough economic conditions in the United States.

However, because it has workers outside the country, it is paying a hefty and unexpected price as a result of the dollar’s decline.

“The biggest impact is the free fall of the dollar,” Mr. Buatois said. He said costs to the company have risen 10 percent to 20 percent in the last three quarters. “But the price of the product is not going up.”

The withering national economy also appears to be having an impact on the amount of money that early-stage investors are putting into start-ups.

In 2007, very early-stage investors — so-called angels — put $26 billion into start-ups, according to the Center for Venture Research at the University of New Hampshire. That figure represents no increase from the year before, after large increases every year since 2003, when the Valley emerged from the bust.

“Since the climb back, this is the first flat year,” said Jeffrey Sohl, the center’s director. He said the money was being spread over more start-up companies, which means the average amount going into individual start-ups from angels has fallen to $450,000, from around $500,000.

“It’s not a crisis in confidence, but it is a more cautious approach,” Mr. Sohl said of the perspective of investors, whom he said may also have less to invest in new companies because the market’s decline has diminished their capital.

The caution is likely to hinder job growth. The Center for the Continuing Study of the California Economy projects there will be 10,000 new jobs in the region this year, down from 17,700 last year, and 25,000 in 2006

Another seemingly unrelated but potentially crucial financing issue has come from the paralysis in the market for so-called auction-rate securities. These are investments that individuals and companies have used to park money for short periods, with the knowledge that they could quickly retrieve the funds. Many venture capitalists have relied on such investments but are finding they are unable to get their money out, which in turn is threatening their ability to pay bills at their start-ups.

But the most troubling specter for the tech economy has been the stalled stock market and the impact it has had on the ability of investors and entrepreneurs to go public for personal profit and to raise money to continue to build their businesses.

At the end of the fourth quarter, there were 60 venture capital-backed companies registered to go public. By the end of the first quarter, 38 were registered. And some of those have since withdrawn their registrations, said Mark G. Heesen, president of the National Venture Capital Association.

“That’s how quickly it turned,” Mr. Heesen said, adding: “It is not good news, and we are not trying to sugarcoat it at all.”

There is a trickle-down impact, he said. “For Silicon Valley, it means fewer start-ups funded, fewer entrepreneurs funded, fewer employers that you hope to be the next major employer.”

Via NY Times