The Wall Street Journal-20080215-In Silicon Valley- Start-Ups Begin Hitting the Brakes

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In Silicon Valley, Start-Ups Begin Hitting the Brakes

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Silicon Valley was flush with cash and optimism just six months ago. Now as the region stares down the barrel of a possible recession, start-up companies and their investors are beginning to hunker down and tighten their belts.

Small companies like Etsy Inc., which sells homemade crafts online, and Blackwave Inc., a video-storage outfit, recently raised funds partly to build up financial cushions in case business turns south. MFoundry Inc., which sells software to the banking industry, says it is holding the line on nonessential spending and making only critical new hires.

Online-jewelry retailer Ice.com Inc. is so worried about a possible drop in consumer spending that it loosened credit terms for customers in December. Now those who buy baubles of $300 or more on the Web site can spread their payments out over 10 months, instead of five, interest-free.

"We're very cautious about where [the economy] is going," says Shmuel Gniwisch, Ice.com's chief executive. If the economic picture worsens, "we'll definitely have to retrench and think about what we are doing." Last month, Ice.com raised $47 million from venture capitalists, partly to protect itself against a downturn. Many venture capitalists are making big investments despite the broader economic worries, as many of them raised big funds last year and need someplace to park their cash.

In Silicon Valley, the engine of the nation's high-tech economy, optimism is a guiding force -- and few start-up executives and investors believe a recession will wipe out the tech landscape the way the dot-com bust did eight years ago. Big deals are still being done, as evidenced by Microsoft Corp.'s bid for Yahoo Inc. Many new Internet companies also continue chugging along, having not spent as profligately as start-ups did during the late 1990s boom.

But what happens on Wall Street does eventually trickle down to Silicon Valley. So many entrepreneurs and venture capitalists -- who invest in small companies in the hopes of taking them public or selling them later -- are hedging their bets. Among their worries: that a tough economy will slash big companies' spending on the products sold by start-ups. It may also damp online advertising spending, which has fueled many Web companies over the past few years.

A University of San Francisco survey of venture capitalists, released last month, found their confidence in the San Francisco Bay Area "venture entrepreneurial environment" at a four-year low.

U.S. venture investors raised $34.7 billion in 2007 -- the most since 2001, according to the National Venture Capital Association and Thomson Financial -- and are still hoping to invest those funds and see payouts in five to 10 years.

But if a recession comes, "my guess is that we'll start to see [corporate] tech budgets, and advertising budgets, flatten or decline," says Dan Nova, a venture capitalist with Highland Capital Partners in Lexington, Mass. "Obviously that would have a ripple-down effect on venture-backed companies." He says two start-ups backed by Highland, which he declined to name, have already decided to delay initial public offerings because of market uncertainty.

To gird themselves, some venture capitalists are urging companies in which they invest to raise more money now because it may be harder to convince investors to give them cash later in a tough market. Other investors are passing up hot deals that look too pricey, concerned that overvalued companies have no hope of going public or being acquired for a commensurately high price if the economy dives.

The investor concerns have spurred entrepreneurs such as Blackwave CEO Bob Rizika to build a war chest of funds. His Acton, Mass., start- up raised $16 million in October from investors including Sigma Partners, Globespan Capital Partners and IDG Ventures. While Blackwave only needed $12 million to $14 million, Mr. Rizika says he wanted the extra cash to create a "buffer" should the economy tank. Blackwave also decided to forgo expensive advertising and instead directly market its offerings to 10 or 20 target customers.

"If you can raise more, you should raise more," Mr. Rizika says. "You don't know what's going to happen."

Few start-ups are reporting lower sales or laying off employees -- but some are starting to feel the pinch. Venture-backed companies that sell products to the financial-services industry, which has been walloped by subprime mortgage-market woes, are finding it tougher to make sales. MFoundry, the Sausalito, Calif., company that sells phone software to banks, says that while sales to existing customers remain steady, about 2% to 3% of banks it has contacted recently said they can't spend money on new technology.

The banks said, "'We can't even think about this right now because we're in a world of hurt,'" says Drew Sievers, mFoundry's co-founder and CEO. MFoundry's anchor customer is Citigroup Inc., which recently reported a $10 billion quarterly loss driven by $18 billion in mortgage- and debt-related write-downs.

Before Christmas, mFoundry's management huddled with its investors at a board meeting, and agreed sales would likely slow in this year's second quarter, Mr. Sievers says. He is optimistic about the business, but mFoundry still might slow hiring and delay a planned international expansion.

Real-estate industry start-ups also have been stung. Online real- estate broker Redfin Inc. says transactions sank 41% in September compared with August as it became harder for home buyers to get mortgages. While sales have since rebounded, Redfin CEO Glenn Kelman says his start-up in September developed some "contingency plans" for cutbacks, such as curtailing hiring and delaying moves into new U.S. cities. When business improved in October -- perhaps because the company's discounted services appeal to bargain-hungry consumers -- Redfin went ahead with its original expansion plans.

Still, to boost its agents' sales and counteract any future slowdowns, staffers recently spent six weeks combing through data about home sales brokered through Redfin and came up with a set of best practices that its agents started using in December. Among them: always start a new home listing on the Web site on a Friday, and put listings on Craigslist.com, which was shown to be effective in boosting sales.

A few start-ups are less worried about a possible recession. Tagged Inc., a social-networking site aimed at teens that has raised about $8.5 million in funding, is still ordering in lunch and dinner every day for its 36 employees and offering them free gym memberships and monthly massages. If it abandoned such perks, Tagged would have a harder time recruiting top-grade engineers, says 28-year-old co- founder Greg Tseng.

"Even if advertising did slow or drop, it would still be just one of a ton of risk factors for a start-up," he explains. So far, Tagged has been focused on acquiring users and getting them "really engaged in the site," he says. As far as building a new, robust profit model? "We definitely need to figure that out," he says.