The financial crisis makes it harder to get funding, but those that prove themselves during this period will be better positioned to thrive

By John Tozzi

Landing venture capital is tough for startups (BusinessWeek, 2/1/08), even in a good economy. But given the ongoing financial crisis, how hard is it for early-stage companies to get funded right now? Venture capitalists say entrepreneurs face a much higher bar than in recent years. They liken the downturn to a period of natural selection, when weak businesses will fail but strong ones will prosper. New companies that prove themselves now, they say, are better positioned to thrive when the economy recovers.

“Almost by definition the entrepreneurs who have the moxie to walk through your door in tough times tend to have better ideas,” says Mike Goguen, a VC with Sequoia Capital in Menlo Park, Calif. Goguen says many of Sequoia’s best-performing companies have been founded around down times. Today, VCs report seeing stronger proposals from more serious entrepreneurs than in years when the economy was stronger.

Venture firms are still investing, and they emphasize that they have plenty of money to back good business ideas. But funding has slowed. U.S. venture funds invested $7.1 billion in 907 deals during the third quarter of 2008, down 7% from the prior quarter and 9% from the third quarter of 2007, according to the MoneyTree Report from the National Venture Capital Assn. and PricewaterhouseCoopers. “The funnel for dollars is becoming smaller and smaller,” says Mark Heesen, president of the NVCA. VC funds also have to commit more time and capital to help existing portfolio companies weather the downturn while the potential for exits through acquisitions and initial public offerings has greatly diminished (BusinessWeek, 10/14/08), he says.

Cash Flow Proof

For entrepreneurs running startups, the game has changed. Speculative business models won’t get funded, says Bob Ackerman, co-founder of Allegis Capital in Palo Alto, Calif. Companies need to demonstrate that their value proposition is real, and that they can hit measurable benchmarks toward generating revenue and positive cash flow, he says. In an environment where consumers and businesses are cutting spending, entrepreneurs need to ask, “Is this a company that absolutely must be started now? Or could this wait a couple years with no apparent penalty?” Ackerman says.

Startups also need to prove they can build lean organizations that use the money invested efficiently (BusinessWeek.com, 10/12/08) to get to profitability, says Pascal Levensohn, founder of Levensohn Venture Partners in San Francisco. “A year ago, somebody would have walked in and have been told that they shouldn’t be asking for less than $5 million for a Series A because otherwise it’s too small to get institutional venture capitalists interested,” he says. Now companies should be prepared to discuss the minimum amount of money they need to validate their business models. Once the concept is proven, Levensohn says, larger follow-on investments can help it scale.

Entrepreneurs seeking investments should also be prepared for lower valuations (BusinessWeek.com, 11/7/08). As other sources of financing vanish, VCs enjoy a buyer’s market and will expect a larger share of equity from companies they invest in, says Heesen. It’s a silver lining for venture funds: “There are very, very good deals out there if you have the time and the money to be investing in them,” Heesen says.

Timing It Right

With that in mind, some entrepreneurs are waiting longer to raise capital if they can afford to, says Divya Gugnani, entrepreneur-in-residence at FirstMark Capital in New York and CEO of culinary Web site Behind the Burner. “The value of their company goes up when they spend six months or a year getting it off the ground,” says Gugnani, who is also a venture capitalist. Startups that can bootstrap long enough to turn their ideas into products and demonstrate revenues will get better valuations, she says. “More people are being more intelligent about when to raise the round.”

Companies with enough capital right now should use the downturn to strengthen relationships with customers and potential future investors, says Aassia Haq, CEO of online talent marketplace Alumrise. She says her four-person Plano (Tex.) startup has enough funding from angel investors to operate well into 2009, and she is not actively trying to raise money now. “We start with fostering ties and relationships, and those things take a long, long time to come to fruition,” she says. “I think a great investment in this economy is to continue to meet smart people face to face.”

But those startups strong enough to succeed now shouldn’t wait to seek funding just because of the economy. “Please do not think that because the economy’s bad it’s a bad time to start a company if you have the right idea,” says Sequoia’s Goguen. Businesses born during the downturn will need to operate more efficiently and deliver more value to customers than companies launched during boom times, but they’ll be stronger for it. “The toughest environment forges the strongest companies, and the toughest entrepreneurs are the ones who tend to show up these days,” says Goguen.

Tozzi covers small business for BusinessWeek.com.