If you have had a pleasant summer caving in Montana you might have missed out on the fun that has been had in the financial markets over the summer.  Here’s a summary – the market for the creation and packaging of mortgages froze.  This resulted in the grinding to a virtual halt of origination and trading activities in unrelated corporate debt markets.  The world’s central banks stepped in to provide liquidity to grease the wheels of the debt markets. And, the stock market gyrated like a school yard seesaw with sugar rushing 8-year olds on each end.

Having brought everyone up to speed, what does this all mean to the technology entrepreneur. Should you be worried about this?  Well, yes and no.  But, before getting into that in detail, let’s take a moment to examine what is going on behind the curtain.

The mortgage markets stopped working because there was a disconnection between the perceived reward and risk for originators and purchasers of mortgages.  In other words, the specter of defaults by households of their obligations to mortgage holders created a concern that the interest rate paid to holders of the mortgages was insufficient to compensate them for the risk of making the investment.  What made the issue particularly problematic is that individual mortgages aren’t held by the originator (i.e., the bank or finance company), but instead are “packaged up” into larger groups of mortgages which are purchased by investors.  As these mortgages are packaged together they are often sliced and diced into separate pools (or packages) which are expected to have different risk characteristics (for example, a pool of mortgages from borrowers with high credit ratings). 

As data became available that defaults among mortgagees (the people who borrowed the money to begin with) were rising, mortgage market participants found themselves in an interesting dilemma – they couldn’t properly evaluate the risk in their investments because they couldn’t comfortably figure out what was in the mortgage packages they owned.  And, because they were uncomfortable with their ability to assess risk, they did what investors always do in that situation – they stopped and waited for the situation to get clearer.  Problem is that when investors stop and wait, the wheels of commerce are affected.  People didn’t immediately stop wanting to get mortgages and businesses don’t stop needing credit. So, disruptions occur and they spread to other markets.  Think of a stone hitting a pond and the ripples in the water that result.

There are many examples in our recent economic history of what I will call “risk reevaluation moments.”  You might remember the post-911 risk reevaluation moment, when investors in the US equity markets wondered if the risk of owning technology stocks outweighed the financial benefit.  There have been others. Remember the risk reevaluation moment when the high yield bond market couldn’t finance LBOs in the late 1980s.  How about the risk reevaluation moment when a high profile hedge fund failed in 1998?  How about when the US stock market crashed in 1987?

Here’s my point.  Some times risk reevaluation moments cause widespread and lasting changes to our collective economic circumstances. And, some times they pass quickly.  Why some and not others?  That is a complex question that is outside of today’s blog, but the short answer is that when a market change profoundly affects the psychology of consumers, it is more likely to be a big problem.  And, generally when a systemic change is great enough to affect consumer psychology it has a near term adverse effect on emerging technology companies.

It’s probably not surprising, if you think about the whole ecosystem of emerging companies from the perspective of an optimistic economy.  Entrepreneurs have to feel confident that if they fail they will still be able to find other employment.  Employees have to believe that if they “take the risk” of joining a start up, that it will be successful, or at least that they can get a more secure job if the start up fails.  Angel investors need to feel secure and prosperous enough to provide capital to risky businesses.  And, professional investors need to believe that stock market investors and strategic acquirors are ready to purchase promising companies.  In other words, start ups just do better in an optimistic environment.

Having said all that, where are we now?  Well, the mortgage market and other credit markets are working towards some type of equilibrium. The Federal Reserve and other central banks have acted, and I suspect will continue to act, to provide sufficient liquidity to allow the markets to safely reassess the risks of mortgage origination and trading and reach a new consensus that will allow mortgages to be originated and traded smoothly.  The system will not fail, and we will not have a world wide economic depression.  However, there are going to be some lasting changes, which will affect the system.  It will be much, much harder for the less creditworthy to get financing to purchase new homes.  The prices of homes, particularly in areas where many homes were purchased by the less creditworthy, will fall significantly.  Additional hedge funds and mortgage aggregators will fail, perhaps spectacularly.  US interest rates for less credit worthy borrowers will increase.  And, the US government’s role in the mortgage origination market will grow.  For a portion of US consumers this is going to be a very, very bad time.  How large a portion will therefore dictate this summer's effect on the start up market.

In the near term, the effect of the summer’s credit market turmoil on the start up market should be minimal.  The overall economy remains strong, and consumers generally remain optimistic when compared to historial levels.  More importantly, there has been a large amount of wealth created in the US and international economy which will continue to look for strong investments.  There will be continued anxiety in the US financial markets as this most recent risk revaluation moment works its way through, but overall it seems unlikely that the overall economy will deteriorate into a recession. 

Going into the fall, I’d recommend that the prudent technology entrepreneur consider some of the following actions:

• Keep a close eye on the behavior of US consumers.  Are there signs of a general change in sentiment?

• If you have funding requirements over the next 12 months consider seeking your financing now.

• Make plans to use your existing and future cash as efficiently as possible.
  
  
• Think about the international competitiveness of your business idea.  Would it be attractive to non-US investors or customers?

• If you are planning on an exit and your exit depends upon a purchase by a financial investor you might want to hold off for the moment.  These types of investors are most adversely affected by the current issues in the credit markets.
  
  
• Where you are intending to use credit to finance your business anticipate providing more collateral or other assurances.  Be prepared to pay a higher interest rate.

• Don’t assume that the market that existed two months ago is the market today, or will be tomorrow.  Be nimble.

I should add that in the longer term, whether or not the US consumers are generally affected adversely by this summer’s risk reevaluation, some of its aspects will be good for the venture capital market (and therefore, ultimately good for the entrepreneurs that depend upon access to such capital).  Particularly, one of the causes of this summer’s problems – the lack of transparency – is likely to result in greater scrutiny by regulators and investors of pooled investments and blind pool investing (i.e., hedge funds).  Any diminishment in the attractiveness of hedge funds is likely to result in an increase in attractiveness of more transparent investments. 

In that case, venture capital funds, which invest in a particular asset type (emerging companies) with a high historical rate of return, are likely to benefit from capital inflows.  In other words, regardless of this summer, the US market for emerging technology companies will remain well financed and internationally attractive.  There may be bumps along the way, but a long term perspective should be rewarded.