Facebook flop means hard times ahead for startups — Y Combinator’s Paul Graham is worried

Paul Graham is the genius behind Y Combinator, one of the first startup incubators and the birthplace of immediately recognizable companies such as Reddit, Scribd, Disqus, Dropbox, Posterous, and many, many more. So if he gets worried, people listen.

Right now, Graham is worried. Worried enough, at least, to send a letter to the companies currently in the YC startup program. And that’s likely to make a lot of other people worried.

What’s the problem? In a word, Facebook:

 … I had dinner recently with a prominent investor. He seemed sure the bad performance of the Facebook IPO will hurt the funding market for earlier stage startups. But no one knows yet how much. Possibly only a little. Possibly a lot, if it becomes a vicious circle.

If funding becomes a problem, startups are forced to raise money at a lower valuation than earlier funding (a “down round”) … or may not be able to raise money at all.

What I do worry about is (a) it may be harder to raise money at all, regardless of price, and (b) that companies that previously raised money at high valuations will now face “down rounds,” which can be damaging.

There is a solution, however: be profitable.

The best solution is not to need money. The less you need investor money, (a) the more investors like you, in all markets, and (b) the less you’re harmed by bad markets.

I often tell startups after raising money that they should act as if it’s the last they’re ever going to get. In the past that has been a useful heuristic, because doing that is the best way to ensure it’s easy to raise more. But if the funding market tanks, it’s going to be more than a heuristic.

For some of us in the technical world, it may be a little hard to imagine one IPO having so much of an impact. Even though Facebook’s IPO losses have been crushing blows to some, it seems obvious to others that after assembling such a massive audience, the world’s largest social network will not fail to find ways to monetize. Even on mobile, because they really haven’t even started trying yet.

However, financiers and venture capitalists may look more at the pure financials of the situation, see major losses, and overreact. Financial markets are, after all, not exactly rational. That’s why there are tulip bulb crazes and dot-com blowups.

As Graham says,

The startups that really get hosed are going to be the ones that have easy money built into the structure of their company: the ones that raise a lot on easy terms, and are then led thereby to spend a lot, and to pay little attention to profitability. That kind of startup gets destroyed when markets tighten up. So don’t be that startup. If you’ve raised a lot, don’t spend it; not merely for the obvious reason that you’ll run out faster, but because it will turn you into the wrong sort of company to thrive in bad times.

What’s your opinion? Do you think the Facebook IPO could have a catastrophic effect on capital markets?

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