Ip Os: Slip Sliding Away?

Sinking stock prices could undercut incentives to back high-tech innovation--and slow the New Economy

As the saying goes, be careful what you wish for. Many economists have welcomed the recent decline in the stock market, in response to a series of interest-rate hikes by the Federal Reserve, as a way of removing some of the inflationary pressure from the economy.

With the Nasdaq Composite Index down more than 30% since its March peak, however, investors have become reluctant to put money into initial public offerings. In May, IPOs raised only about $1.8 billion, down from a monthly average of $6 billion in the first quarter of 2000 and almost $10 billion in the fourth quarter of last year. At least 30 companies withdrew their planned IPOs in May, with other companies dramatically paring back the amount of money they hoped to raise.

Of course, part of this pullback represents a healthy retreat from speculative excesses. But if the erosion of funding for high-tech startups continues, it could have broad macroeconomic consequences. Over the past few years, the easy availability of funding for new companies has played a crucial role in the rapid pace of change in the New Economy. Venture capital and IPO money do not create new technology, but they do speed the rate at which new applications move to market. That's because good ideas get funded more quickly and on a larger scale. Moreover, the availability of financing enables entrepreneurs to take chances on risky businesses that could have big payoffs. The result is faster economic growth and bigger productivity gains.

"SPECULATIVE EXCESS." The implication: A substantial further decline in the Nasdaq or a continued stall in the IPO market over the next few months could erode one of the key pillars of the New Economy. If new businesses have to struggle for funds, new products and services will get to market more slowly, riskier businesses will not get funded at all, and there will be less competition for existing companies. "There certainly have been signs of speculative excess" in pockets of the stock market, says William A. Sahlman, a professor at Harvard Business School. But, he says, "the productivity increases coming out of these pockets of inflationary pressure have been huge."

So far the damage from the IPO pullback has been minimal, since many tech outfits are still flush with proceeds from lucrative IPOs of the last six months. And despite the weak market for IPOs, many new businesses that are not yet ready to go public still have access to plenty of venture capital. More than $17 billion in venture deals were announced in April and May, about the same pace as the record-breaking first quarter.

In May alone, RealPulse.com Inc., a business-to-business Web site for commercial real estate, took in $140 million in venture financing. WWW.COM, a Los Angeles-based provider of music and entertainment on the Internet, received more than $40 million in venture capital. And Carolina Broadband, a company that is building a broadband network for cable, Internet, and telephone services for North and South Carolina, received a monumental $400 million in funding. "We haven't noticed much slowdown," says Kenneth M. Andersen III, managing editor of VentureWire, an online newsletter that tracks venture capital deals.

But the flood of money into venture capital is likely to be temporary if the stock market falls further. History suggests that when the IPO market turns down, venture-capital funding eventually follows, since there's no reason to take the large risks associated with funding startups without the lure of a big payoff from an IPO. Typically, there's a lag of about a year or so from a drop-off in IPOs to the time it shows up in the venture capital market. That's how long it takes before venture capitalists start exhausting the money that they have previously raised from pension funds and other large investors. Moreover, as the effects of the falling stock market take hold, individual investors known as angels begin dropping out of the venture-capital market, since they are putting their own money at risk. Corporate venture funds, too, tend to pull back at early signs of trouble, since that's not where they want to put their management attention.

As that happens, it can become more difficult for early-stage startups to get money. Such startups have been a critical conduit for innovation in the New Economy. The underlying breakthroughs in basic science and technology generally have come from government, university, and large corporate labs. But it's been such venture-funded companies as Cisco, Netscape, Amazon.com, and Commerce One--the B2B company helping to build a giant online market for auto makers--that have been responsible for the accelerated creation and introduction of innovative applications and products into the marketplace.

What's more, there is a multiplier effect from venture capital and IPO funding. The competitive threat from well-financed startups spurs existing companies to adopt new technology far faster than they would otherwise. Netscape Communications Corp.'s ability to obtain financing from venture capitalists and an oversubscribed IPO made it a much more credible threat, forcing Microsoft Corp. to accelerate its move to the Internet. Similarly, dot-com competitors forced relatively stodgy brick-and-mortar companies to create Web sites and shift to an Internet strategy much faster than they would have done by themselves.

"SINKING FEELING." A well-functioning venture-capital and IPO market is one of the key factors differentiating the U.S. from Europe and Japan. Technology can always be bought or transferred across national borders. But until recently, the U.S. was the only country, in the words of Treasury Secretary Lawrence H. Summers, "in which entrepreneurs may raise their first $100 million before buying their first suits." Only now are Europe and Asia developing the beginnings of financial markets devoted to funding innovative young businesses.

With much of its earlier momentum now drained from the U.S. market, there are some incipient signs that the euphoric days of open-door funding for new firms may be over. For one, entrepreneurs are having to give up a larger share of their companies in exchange for venture funding. Take NetNumina Solutions Inc., an e-business systems integrator and consulting firm. On May 9, it closed on $25 million in venture financing, a relief after "watching the Nasdaq with a sinking feeling," says Imran Sayeed, CEO of Boston-based NetNumina. But it meant accepting a lower value on his company from venture capitalists. "You could hear them cringe at the valuations we asked for," says Sayeed. "Now they're singing with glee."

At the same time, venture-capital funds are paying more attention to "P2P," or "path to profitability." They demand a business model that plausibly allows for profitability in the near future. That means more money for companies building the communications infrastructure, such as Carolina Broadband, and less for e-commerce and applications companies.

The changes may not be all bad. Many longtime venture capitalists welcome the prospect of less money flowing into the industry. They argue that businesses were funded which had no good reason for existence, and worthwhile businesses had more money thrust on them than they could handle. Now, "You'll have better companies, built for the right reasons," says Bob Kagle, founding partner and general partner of Benchmark Capital. "People have to see that there's no free lunch."

But too sharp a decline in the stock market is likely to exact a big price, if it means a retreat in IPO and venture capital markets. U.S. prosperity depends on innovation in the information technology and communications sectors. Weak stock prices will eventually mean that fewer and fewer new companies get funded, for less and less money. In the end, that isn't good news for the New Economy.

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