Withering Nasdaq Crunches Cash-Hungry Tech Firms

It wasn't that long ago that finding funding was easy for technology start-ups.

With the Nasdaq surging, money was flowing freely, from venture capitalists and from the equity market, and any young turk with half an idea could get some. People began describing their businesses as "plays," as in "I work for a B2B platform play" or "I'm with an e-commerce wireless play." Or maybe, if they were at Pets.com (IPET), Petopia.com, PetStore.com, PetSmart.com, PetPlanet.com, AllPets.com or PetWarehouse.com, "I work for a B2C pet products play."

Round-Tripping Nasdaq plunges below year-ago levels

Those days are over, as evidenced by Pets.com's decision last week to shutter operations after finding neither a buyer or backer. For anyone trying to get a business off the ground, cash just isn't as easy to come by anymore. And with equity and debt markets drying up as the Nasdaq plunges, cash-strapped companies of all stripes are facing a bleak winter as the bills come due.

Full Circle

It begins where it started, with the equity market. Over the last year the Nasdaq rose 60% and gave it all, and then some, back. The environment on the way up was one of increasingly easy access to capital, one wherein fast-growing companies could easily raise money in the public markets despite having no hope of reaching profitability anytime soon.

This was making a lot of venture capital firms, which had made the seed investments in these newly public companies, very, very rich. And this prompted piling on. More venture capital shops were launched, and more investors (including some traditionally vanilla public pension funds) gave the VCs money. Venture capital firms are pretty much obliged to invest that money, and they did -- in ever more risk-prone businesses. Nor did this really seem like a problem, since companies could be taken to the IPO stage so quickly. As Peter Fenton, a principal at the Palo Alto, Calif.-based venture capital fund Accel Partners puts it, "There was a lot of reckless investing."

Deceleration? Cash raised by venture-backed Net companies, quarterly

Source: VentureOne. Figures in billions of dollars.

In both the public and private equity arenas, investors had made the mistake of looking at the past growth rates of early-stage businesses and extrapolating them far into the future. As a result, they were willing to accept payoff dates, when these companies would finally turn profitable, a long way off.

Payback

"Capital had been pouring in based on the presumption of huge growth rates that some of the last dollars that came in were actually invested at such a high level that one would have had to wait years for the ultimate payback," explains Banc of America Securities equity portfolio strategist Tom McManus. "What's happening now is that time period is shortening."

In the public markets, that has meant a huge scaling back in high-tech initial public offerings. In October, tech companies raised just $2.1 billion through IPOs, against $7.5 billion in October of last year (and way below the April peak of $11 billion).

Less and Less Cash Money raised in high-tech IPOs, excluding biotech, monthly

Source: Thomson Financial Securities Data. Figures in millions of dollars.

The drop in the stock market and the drying up of the IPO pipeline hasn't seriously constrained the flow of capital to venture capital firm coffers, but there's a sense that the VCs are being much more careful with their investments now. In the Internet sector, which has seen venture financing in general slow a bit over the last couple of quarters, VCs aren't putting nearly as much money into content, business services and e-commerce, choosing instead to invest in infrastructure, software and database companies.

"I think there's increasing business discipline out there, though I still don't think there's enough," Fenton contends. In general, says Fenton, there has been a flight toward firms that are technical innovators -- think CalTech grads, not Stanford MBAs -- and companies whose managements already have proven track records.

Draining

There's also a realization that companies need more runway before going public, and that, in turn, means that they will need more financing. Besides making VCs a bit more wary about what they invest in, because they must put in more to see their investments pay off, it reduces the pool of available capital for start-ups in general. If one company will need twice as much capital to get it to the public market, a second may not get financing at all.

There are other ways to get financing, of course. One is the debt market, but unfortunately that is not much of an option in the current climate. The high-yield, or junk, bond market has been severely restricted for over a year now -- in part because investors pulled money away from it to equities, seeking higher returns. And the one area where high-yield was working -- among the competitive local exchange carriers, or CLECs -- has recently fallen on hard times. One carrier, GST Telecommunications (GSTXQ), was forced into bankruptcy. Another, ICG Communications (ICGX), is trading for pennies.

Withdrawal Symptoms Pulled IPOs this year, monthly

Source: ipoPros.com

The problem is quite similar to what's happened in the high-tech public and private equity markets. Getting a CLEC up and running takes a huge amount of capital, meaning that profitability may be years away. Previously, bond investors didn't worry that the payout would take so long, but in the new environment they've shrunk their time horizon.

"All of these companies are big-project finance albatrosses," explains a high-yield bond analyst at a Wall Street firm. "They usually take several years to get EBITDA positive," he says, referring to a widely used measure of cash flow.

Darkest Before the Dawn

The inability of start-up companies to raise capital may actually be something of a boon to companies that have already moved through the IPO stage and, unlike Pets.com, have enough cash on hand to get them to profitability. Because the door to getting capital shut behind them, they don't have to worry about increased competition for upstarts.

For the companies that were supposed to be the pick and shovel makers for the Internet, however, there may be trouble to come. There have certainly already been murmurings. Last week, VA Linux (LNUX) warned that its fiscal first-quarter revenue would fall below analyst expectations. "Although repeat business with our existing customers remained strong during the first fiscal quarter, sales to new customers in the dot-com sector were below our expectations," said CEO Larry Augustin in a statement accompanying the warning. "In particular, the number of new customer opportunities from venture-funded dot-coms declined faster than anticipated."

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