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In 2008, just as the global economy was collapsing, one of the most storied venture capital firms in Silicon Valley, Sequoia Capital, gave a presentation that encouraged entrepreneurs to raise as much money as they could, and hunker down for a nuclear winter.

Three years later, the startup economy is zooming along. Many young companies large and small have been raising money at significant (and arguably exorbitant) valuations. A new breed of angel investor -- the 'super angel' -- has emerged, buoying the market for startup capital. And thanks to secondary markets for private company stock, founders and early employees at some of the most successful companies have been able to obtain liquidity.

But are the good times coming to an end, again?

According to a report in the Wall Street Journal, the answer may be 'yes.' It explains that "...in recent weeks [some startups] have found it tough to procure new funding, investors and entrepreneurs say...That is pushing some entrepreneurs to look for 'bridge' financing to keep forging ahead, or to cut the valuations they are seeking, the people add."

Naval Ravikant, who runs the fundraising site AngelList, told the Wall Street Journal that the market is "is getting weaker by the week" and that the average valuation for young companies has dropped from $5m to $3m.

There are a number of dynamics at work, observers say:

  • The number of companies that have raised money and which are starting to need new infusions of cash exceeds the amount of number of investors willing to fund them.
  • Some investors are starting to question whether the market is a little bit too frothy, and as a result are being more conservative about their investments, if they're still investing at all.
  • More than a few startups, perhaps used to a free-flowing funding environment in which cash has been on tap, have been burning through the capital they raised previously like it's going out of style.

Not surprisingly, however, some dispute that the end is nigh. Well-known Silicon Valley angels are saying the Wall Street Journal report is way off base. Chis Sacca responded, "I definitely don't agree with the article. Valuations are still high and I haven't seen evidence of cash crunch." Dave McClure implored his Twitter followers, "Folks: lets not confuse reality w/ what we may WANT 2 see -- cash crunch hasn't happnd yet."

But Ravikant, whose AngelList has been featured very prominently in the recent angel funding boom, is sticking by his statements to the Wall Street Journal: "Top tier deals [are] still hot. But [the] bottom [is] falling out. Make your own sub-prime analogy..."

Who is right? A few things are pretty much indisputable:

  • Thanks to the rise of the angel investor (and a new class of super angels), a significant number of startups have been created and funded in the past several years, many with fairly limited amounts of capital (under $1m).
  • The majority of them won't be around in a decade, and more importantly, not all of them will become self-sustaining before they need more capital.
  • Investor confidence is influenced by many external factors. Right now, there are plenty of factors which don't bode well: the possible closing of the IPO window, the impact a Eurozone meltdown could have on the global markets, etc.
  • Venture funds in the U.S. raised less capital last quarter than in any quarter in the past eight years, a reminder that limited partners aren't an endless source of capital.

Inevitably, startup investors, no matter how confident, will have to pick winners and losers. Angels, super angels and VCs will double down on the strongest companies in their portfolios, and abandon the weakest. It's always been this way, and it will always be this way. That means there will be companies desperate for cash, with little hope for survival.

Is a major cash crunch imminent? That we don't know, but any startup funded in the past several years that doesn't have positive cash flow and isn't yet profitable (or close to it) should probably start preparing for the day when the angel and VC well runs dry. That day is coming for many of them.

Patricio Robles

Published 13 October, 2011 by Patricio Robles

Patricio Robles is a tech reporter at Econsultancy. Follow him on Twitter.

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