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The Economy & Entrepreneurs
By Don Sussis
November 15, 2001

During the last few months, I've attended a number of "town meetings" where various groups, such as The New York New Media Association and iBreakfast, have tried to address the lack of capital flowing into Internet companies and the disappointment of entrepreneurs who have seen their ideas sacked. Smart people (such as Alice O'Rourke and Alan Brody) who run these events want to boost the morale of Internet entrepreneurs and workers while at the same time give the industry some direction and confidence. Unfortunately, many other Silicon Alley and Valley leaders now identify with Icarus more than with Bill Gates.

One of the repeated themes voiced by participants in these meetings has surprised me. There are still many people who don't understand that from 1995 until 2000 there was a bubble economy that inflated anything tech related way beyond survival altitude. The basis of this was:

  1. The promise that "the Internet would change everything;"
  2. The fear by "old economy corporations" that "new economy corporations" would "eat their lunch;"
  3. The infusion of capital and liquidity by the Federal Reserve Board to address Y2K fears;
  4. The emergency spending by all companies to become Y2K compliant and to spend whatever necessary to avoid prophesied catastrophe;
  5. The over production and the over-hype of technology companies that new hardware, software and consulting services were necessary to keep up with Y2K and Internet opportunities (including complete new systems that were hastily built, not sufficiently tested, and left at the corporate doorsteps like abandoned children in Cold War Romania);
  6. Research and development functions were shifted to mergers and acquisitions activity as it was "more efficient to buy than to build" -- especially with inflated stock used in place of real currency;
  7. Wall Street used the capital markets to supplement real venture capital and sold too many still born Internet babies to the public because they could, simply, enrich themselves in the process;
  8. Stock analysts were bribed by the investment arms of the firms that fed them;
  9. Corporate balance sheets were inflated by fat valuations put on Internet companies in their own investment portfolios-they often provided profitability without real earnings;
  10. Anyone with "extra money" was an Angel Investor or Tech Stock Investor because "you don't need brains in a bull market;"
  11. For a while everyone with a 401K thought they were rich and would continue to make 20 percent to 50 percent a year on their money;
  12. Anyone under thirty with an "Internet play" (and I do mean to connote theater) could become a millionaire overnight by outlining something they sketched out to people over 30 who would not fully understand their idea but fund it anyway because a) they didn't want to miss-out, b) they were too hip to be square, and c) they too could be Jim Clark or David Weatherall.\

After saying all this, the past should be prologue. But that still doesn't take into account the financial conditions that began on April 14, 2000 when the equities markets began to spiral downward and the bubble began to burst. The catastrophe of September 11, 2001 pushed the nation into recession and a climate of uncertainty. There could be less fudging of numbers and more sober analysis. The cost of the destruction in New York alone, according to the New York Times, hovers around $40 billion -- a huge hit to an already struggling economy. This will hurt all small business initiatives because insurance rates are sure to rise sharply. We are definitely not in Oz anymore.

The list of ailments that came home to reality in the past eighteen months is long and painful. There is the realization that corporate earnings could not continue at their torrid, juiced-up pace. Pro-forma accounting tricks were becoming more familiar than conjuring rabbits out of hats. EBITA, cash flow, comparison valuations, one-time charge-offs for bad investments were seen as shams and scams. Consider, for example a company such as JDS Uniphase, which wrote off more than $50 billion dollars in valuation because the companies it purchased were no longer worth what was paid. Enron, the once mighty energy and broadband trading company, has seen its stock drop from over $70 to under $10 in a few weeks because of their "black box" accounting and internal conflicts of interest. They are now re-stating five years of earnings and being acquired at a fire-sale price because their debt rating has be downgraded, investors have lost confidence in management, and other companies will no longer extend them the credit needed to operate. So, this is more than just a dot-com/dot-bomb phenomenon.

In addition, corporate America had so overbought technology and Internet gear that they didn't know how to utilize the stuff they had bought and manufacturers didn't know to stop making more. This resulted in huge inventory build-ups that had to be dumped or written off as prices dropped, demand diminished and discounting ran rampant. In addition, the failure of Internet companies-more than 350 in the last year (not counting all the garage variety)-flooded the market place with hardly used/ new equipment that was cheaper than dirt.

This created a vicious spiral in which demand and prices raced to an ever-lower bottom. This, in turn, finally made the valuations and recommendations of "analysts" (read: cheerleaders) of the Mary Meekers and the Henry Blodgetts of the world silly even to True Believers. Insiders sold in droves, as did many investors. But the eventual "burn rate" of bad tech, telecom and Internet investments did more than just deprive Internet entrepreneurs of fancy offices and Aeron chairs-it shrunk their savings, exposed their debts and created a real sense of irrational exuberance gone sour. People were not as rich as they had thought.

Forget the losses of three-year options for employees of Internet companies. More than 300,000 jobs have been lost in telecommunications alone. Long time employees of companies such as Nortel, AT&T and WorldCom have seen their pensions melt like ice cream on a hot summer day. Overall, the unemployment claims rate has jumped to 5.4 percent, which is just slightly ahead of Japan's. This doesn't include all of those temporary workers, freelancers, and consultants who aren't eligible to file. It is no longer enough to have just a "big thought" and a lot of ambition. Those days are gone-at least for now.

Still, the sense of wealth prevailed despite evidence to the contrary. Why? Primarily because of housing appreciation and mortgage re-financing. The most important asset a family usually owns is their house. Over the last decade values of single-family homes (and co-ops in places such as Manhattan) skyrocketed. This reinforced the sense of wealth accumulated across the country. In Tech areas, such as Silicon Valley and Plano, Texas or Seattle, Washington, whatever the price paid seemed to be diminutive over time (at least in the minds of real estate brokers) as property values continually increased.

As the economy showed signs of weakening and the stock markets lost value, the Fed began to cut interest rates. It should not be forgotten that many Republicans blamed the defeat of George Bush by Bill Clinton on the recession after Desert Storm and the lack of action by the Fed under the chairmanship of Alan Greenspan.

There would be no such delay this time under George W. Bush. Federal Reserve Chairman Alan Greenspan, who'd popped the bubble by raising interest rates, now raced to lower them. And cut interest rates he has-ten times so far this year for a total of 450 basis points, which brings the fed funds target rate to 2%. That is its lowest in 40 years! The reason is the ever-weakening economy, the drop in consumer confidence and lack of corporate capital spending. Incidentally, the rate has been lowered three times since Sept. 11 when "Operation Infinite Justice" began.

One effect of this has been the re-financing of mortgages. This has pumped around $70 billion into consumer hands. That is one major reason why we avoided "an official recession" before the attacks on the World Trade Center and the Pentagon. The consumer (which accounts for two thirds of the economy) continued to spend because she/he has gotten extra cash on an asset that has continued to appreciate-their home.

With rates now at 6.5 percent on 30-year-fixed mortgages, and going lower, this trend will continue. This was assured last week when the Department of the Treasury announced that it would no longer issue 30-year bonds but rely on the 10-year note as its benchmark. The result is that there is no longer a fully functioning long-term federal benchmark and that the cost of existing notes went up while the yields moved down. This forces mortgage rates to be even more competitive. It is also true that some of the home building and the mortgage sector is artificially stimulated by federal subsidies through Freddie Mae and Freddie Mac, which provide them with liquidity and the ability to securitize their investments as investment instruments.

The result is a cushion for many. But it may also be a hazard for those who bought homes at the top of the market and are now faced with reduced incomes and unemployment. This is one reason why most of the $300 federal tax rebate checks did almost nothing to stimulate the economy. Most people used the money to pay off existing debts or put it into their savings accounts-just in case.

This should tell you something about the current venture climate.

In part two, I'll discuss what new (and seasoned but wounded) entrepreneurs should be doing to catch the eye of potential venture capitalists.

To read part two click here.