Crunch could slow flow of cash into start-ups to a stop

THOSE OF US WHO have been in business for some time have seen economic cycles come and go. When I first raised investment for a start-up company in the mid -1980s, the venture capital community was very new and willing to take risks in technology.

A few disappointing investments later in the 80s things got much tighter, as they did in the recession of 1992, and once again after the dotcom boom and bust in 2001.

But what we are going through this time looks like being the worst ever. This time we have actually lost banks - really big, 300-year-old banks - and this time it is having an effect on pretty much everybody and everything.

The rest of the economy - the real economy - might have been doing just fine when all this hit, but due to the mess that the banks have got themselves into, mostly by over-lending in the housing markets, they have now pulled back their lending and the general consumer economy is suffering badly.

Technology stocks - even big ones such as Apple, Yahoo, and eBay - have taken a pasting, new public offerings have dried up and bigger corporations are cutting back on discretionary expenditure, including on developing new technology and booking digital ads. Of course, Scottish technology companies have not been immune to these pressures, with both Wolfson and aptos shares trading at a fraction of their peak.

So things are looking tough for start-up companies again. The typical path taken by start-ups is to raise first angel funding, followed by venture capital, and then exit by a public offering or a trade sale - all of these stages are now under severe pressure.

Angel funding comes from wealthy individuals who usually take advantage of tax breaks from the Enterprise Investment Scheme. This allows the investor to reclaim capital gains tax (CGT) as long as they invest in early stage companies. The problem with this is that in order to pay CGT you have to actually make a capital gain and, given the state of the stock market, precious few people have now got CGT to reclaim. As a result, I expect angels to put their wallets away for a while.

The kind of risk capital that typically flows into venture capital managers - for investing in early-stage companies - has mostly dried up and VCs will find it very difficult to raise their next fund. Indeed. funds already committed are generally drawn down as needed and there might even be some defaulting on their pledged amounts. Venture capitalists that have money will, of course, have to invest it but they will probably choose to hold back to some extent on putting money into new investments in order to have enough cash to support their existing portfolio through these stormy times.

For not only is the IPO market for new public offerings closed, the number of trade sales is also well down. Accountancy firm PricewaterhouseCoopers says that mergers and acquisition exits have also declined precipitously this year.

And all this might put paid to the 'fremium' model of web company development - where companies provide a service initially for free, build up a lot of customers. and then offer premium priced value-added service once the customer base has been established. With cash at a premium, there might not be enough time for this model to run its course.

How long will this downturn last? Who knows? Suddenly it feels as if we are all navigating without a map.