This post is not about Bubbles, or the popping of Bubbles. If that were the subject, I would have to spend the first few hundred words arguing why I think we are in a Bubble, and let’s face it, that word has been used to death.

So this is not about Bubbles. This post is about business cycles.

The ‘tech’ industry (whatever that means) is mature enough so that it is past time we think of it in terms like that. The whole industry does not have to veer from boom to bust to boom again. Instead, there are expansionary periods and contractionary periods. The difference being the magnitude of the swings relative to the size of the whole industry.

I think its safe to say the industry has had a pretty good run for the past few years. And I believe that things will slow down a bit in the next year or two. This does not need to lead to doom and gloom, we are not talking about bubbles. But I do think it will mean slowing growth rates, a larger number of companies shutting down and a general wave of retrenchment.

So rather than get into an endless “Are we in a Bubble?” debate, let’s assume that sooner or later things slow down. What is that going to look like? I will do a follow-on post about what I think will cause the slowdown, but let me start with the assumption that a key factor will be a slowdown in venture funding, and that there will be concurrent changes to the broader global economy.

Before I get into who suffers most in such a downturn, I want to first look at some general patterns in such situations:

• Downturns have cumulative effects. One company shuts down and its employees are out of work, so they cut back spending on housing and lattes. The company’s suppliers lose a revenue source and react accordingly, possibly shutting down themselves. This adds up, leading to…
• Indirect outcomes are powerful and hard to predict. Management teams (and humans in general) have a hard to time making non-linear predictions. A company’s sales forecast is easy to predict, until it isn’t. Sales pipelines do not work well when customers start to disappear. Your customers’ customers are hard to track. This problem is made worse by….
• The speed at which companies today operate cuts both ways. Companies have become accustomed to things changing quickly. In an upward cycle, this is a management headache and an opportunity. In a downturn, it means the number of ugly surprises multiply.
• Pay Attention to Marginal Costs and Revenues. We have become accustomed to infinitely scalable Internet business models. The truth is that during inflationary periods assets get priced by the case at the margin, meaning the next one sold. This effect has been killing commodities like iron and coal. Small decreases in demand are having outsized impacts on their prices. Finding the equivalent in tech is not easy, but I suspect there will be many things (houses, companies, messaging companies lacking revenues…) where pricing is driven by peak conditions, and thus deflate faster than expected
• A falling tide reveals who is naked. Put another way, hard times reveal true management ability. Many seemingly well-funded companies will collapse because their management teams are either spending much more than was known or they cannot make the transition to new operating conditions. Take a look around your company now and ask yourself how much of the spending is rational and how much is the result of having too much money in the bank?

With that all said, where do I think we will see trouble?

First, there will be some kind of shake-up among mid-stage start-ups. If the venture tap closes, there will be a wave of closures and fire sales among companies that were furthest from their last funding round.

Second, there will be a wide range of outcomes depending on the sector. Companies that are building enterprise sales platforms will struggle as they are likely further away from break even. Companies with no revenue model, hoping for a sale, will find their backs against wall very quickly. SaaS models and many Internet businesses will likely fare well, if they have reasonable burn rates. Here, I am thinking of companies like Uber and Airbnb. These businesses are highly capital efficient, and in theory can ‘flip a switch’ from growth investing to cashflow conservation. (I could write a whole other post on how this is not actually such an easy switch.)

Those are the direct impacts, but I think the bigger problems will come from indirect effects. Predicting the losers in a bad business cycle is always full of surprises, and part of the motivation in writing this note is to help me think through the less obvious victims.

So the third bucket of victims are companies that are recipients of start-up spending. If I were a venture investor, I would take a hard look at where my portfolio companies are spending their money, and then avoid investing in those areas. I think there are a number of sectors that are going to struggle. Even the best-funded companies can falter if their customer base evaporates. Here, I am thinking of the (far too) many ad tech start-ups and ad networks; developer tools and other developer focused companies. In addition, I think there are many service-oriented start-ups (insurance, catering, benefits, accounting, etc.) that begin life targeting other start-ups. While Zenefits is sufficiently funded for the next decade, anyone looking to follow in their footsteps may find a much smaller universe of early customers.

Fourth, I think that many companies from the ‘previous generation’ of start-ups will fall on hard times. Last week Zulily reported some bad numbers and saw its stock take a real beating. I do not see that as a harbringer of an e-commerce meltdown, but I do think it shows how quickly once-hot companies get surpassed. That process gets accelerated when the whole industry turns down.

Fifth, something bad will happen to the angel investing process. I do not mean that angel investing is bad, but it is one area that has seen some abuses, having grown too quickly. To be clear, I am really thinking of the large and growing number of angel investment groups comprised largely of newcomers to venture investing. I am sure Angel List will be fine, but there are now many other ‘amateur’ groups out there. My sense is that these groups will take a big hit, having over-funded too many companies with limited potential. I believe that it is too easy to get seed funding now, and this will inevitably lead to a shake-up.

Sixth, it is unclear if there will be a systematic impact on the broader economy. This is what made the 1990’s Bubble so pernicious, it covered so many sectors (telecom, media, Internet) that its bursting brought down the broader economy. Unless things get truly out of hand, I do not see that happening this time. However, it seems likely that any shakeout in the tech industry will also likely take place at the same time as shakeouts in other parts of the economy. I think risky assets everywhere will slow at the same time venture investing slows. These things will be concurrent but not connected, and the distinction may get lost.

Finally, I come to the inescapable conclusion that the biggest victim of a downturn in tech spending will be the San Francisco real estate market. As a homeowner here, the smart move would probably be to sell my house. That is not going to happen, but when the ‘tech industry’ does enter its contractionary phase, the bubble of San Francisco real estate will pop.