The downside of an over-capitalized market

I recently took the opportunity to visit with influential friends and colleagues in the New York City technology space. I sat with longtime friend Nick Chirls, founder of Notation Capital, and discussed early- and later-stage seed funding. Similarly, at a dinner with friend and colleague Rameet Chawla, we took stock in the state of affairs from the perspective of technology services.

To add a bit of color, Nick’s fund is very focused on early-stage New York City companies, and Rameet and I both run established technology services businesses. These combined perspectives provide an ideal barometer of current technology affairs.

There’s been a lot of chatter over the last five months about market saturation and thus re-correction. The basic questions being asked are: Is money really drying up? Are engineers out of work? Are sales slowing?

All of these concerns seem to indicate a changing climate.

The short answer is fairly simple. Like most things in life, market re-correction is a bit overhyped. We are not experiencing the next dot-com or housing crisis. People love drama and, even more, fear. That is, after all, what sells papers. Funds are still funding; it’s just slower and more calculated. Furthermore, funds are more likely to remain focused on doing follow-on financing rounds within their existing portfolio.

It’s not the best climate to start a new technology business, but it’s far from the worst.

On the services front, deals continue to flow in. There has been little indication of a changing tide, but we’re probably a few months out before we see any potential decrease. As new business venture funding does slow, fewer companies will be started and capital as a whole will continue becoming much more difficult to attain.

These subtle shifts are not totally negative. Historically, as institutional money gets harder to raise, it keeps entrepreneurs honest and new ideas in check while letting the select few winners mature. After all, it should require more than a lunch meeting to get financing for another social network.

While the drama and hype may be a bit exaggerated, there is some truth to the noise that should not be overlooked. Over the past four years, we’ve experienced exceptional ballooning of company valuations, as well as cheap money and gigantic, unjustifiable acquisitions that simply perpetuate higher valuations.

Companies are forced to go public to support their valuations; once Wall Street gets a hold of them, the music stops. Wall Street holds no prisoners, and technology is no exception. As the music continues to stop, late-stage private companies begin to get squeezed. Down rounds, layoffs and reality sets in; the unbearable conversations about users versus revenue commence.

Forcing revenue and profits is really very hard. When the industry for the past seven years rewarded high spend for perceived growth and/or “value,” it’s no surprise that founders are dumbfounded when their respective boards begin asking the very difficult questions about how they intend to make money.

The lessons we have learned from the past are that making money is actually very hard. And even more importantly, we still don’t understand the value of a user. The larger message is that the model of deferring revenue and/or profits to the future has only worked for very few. Pushing the conversation to the future makes mid- and late-stage businesses too leveraged, which, in turn, makes the larger market brittle; hence, where we are today.

While we’re not in the middle of another dot-com or housing crisis, we are again seeing the downside of an over-capitalized market. It’s not the best climate to start a new technology business, but it’s far from the worst. The larger hype of the demise of technology is just the standard fear machine doing what is does best. Raising money will be more difficult for the next 15-24 months, but it will help separate the true businesses from the ideas.