Delevering Our Balance Sheets

This is going to be a big theme in the coming years. My partner Albert wrote three posts last week looking at the explosion in household debt, corporate debt, and financial sector debt in the past 40 years. He’s got a bunch of charts in his posts but they all look something like this:


We have witnessed a massive borrowing binge in this country over the past 20 years and it’s been particularly nuts in the past 10 years. Rates have been low, lending standards even lower, and everyone has been borrowing. Its true that much of the household debt is collateralized against homes and will be either paid off over a 30 year amortization schedule or foreclosed on, liquidated and written off. I think the household debt chart has nowhere to go but down over the next five years.

Corporate debt and financial sector debt are in some ways bigger problems. We are going to see a wave of bankruptcies in the corporate sector as this recession hits over levered corporations hard. And we’ve already seen the financial sector implode as a result of over levered balance sheets.

Albert didn’t really share with us his conclusions from his work. But I think it’s pretty obvious. Much of the cash flowing through households, corporations, and banks and brokerages will go to delevering activities in the coming years. There’s really no place to go but down on these charts.

This will stifle the economy, impair spending, and make it very difficult to get the economy growing again.

The markets are already reacting to this. Stocks have come way down and many think they will come down even further as Q4 2008 and 2009 earnings start coming in. Another factor to think about is that investors are moving from the equity markets to the debt markets. Debt has seniority to equity and when debt is trading at prices that can generate equity like returns, public market investors will do the sensible thing. Both of these factors don’t bode well for the equity markets for the next several years.

So is there a ray of light anywhere in this analysis? I think so. Venture capital does not rely on leverage. Startup balance sheets (for the most part) have little or no debt. The Internet takes costs out of the system and allows consumers and corporations to get more for less. We are working in one of the few bright spots of a badly broken economy.

But we should all be prepared for a long slog out of this mess during which capital will be less available and at lower valuations, exit opportunities will be few and far between, and revenue will be hard to come by. It will not be for the faint of heart.

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Comments (Archived):

  1. AndyFinkle

    You (and Albert) have hit on a “mega-trend”, the de-leveraging of the Great Debt-Pression. We (USA) are the new Japan. I would add, that as a VC (I am not one), I would think that an upcoming category of investment I would be looking at would be companies that leverage the Internet to ring costs out of the system.It bothers me that we are able to safely and securely handle billions of dollars in online transactions, and yet we can not move the process of Voting online?? I would like to see Government take a really broad swing at this. Let’s close up all the physical government infrastructure one by one. Dept. of Motor Vehicles? Online only! IRS? Online only! Voting? Online only. This process should be a political mandate, one that we as taxpayers should

  2. jon

    many start up founders run high debts (e.g; credit cards) to bootstrap their prototype. Any thoughts on how the shortage of debt can impact the first steps of a start up?

    1. fredwilson

      The chart in my post suggests that consumer debt (which credit card debt is a part of) is not the biggest part of household debtBut I think there will be pressure on that tooIt may well be harder to finance a startup on a credit card going forward

      1. jon

        Good point. But still, even if they are not defaulting those cards, will they take on extra consumer loans to finance a start up?On the other hand, “Reports indicate that a substantial portion of of the 158 million US card holders using 1.5 billion cards have started defaulting and banks had to write of approx $21 billion in bad credit loans in the first six months of this year and expect a further loss of $55 billion in the next 12 months (…)According to Federal Reserve figures, in the US alone more than $850 billion in unpaid credit card balances is at stake and fast approaching $1 trillion, roughly the same amount as in the subprime market.” Of course, that will have larger impact on the consumer base of those start ups than on the start up financing process…but it si still worth sharing I think.

        1. bernardlunn

          Jon, you hit a key point in my experience. The view has been that you needed traction to get VC and those 0% teasers looked attractive to the optimistic entrepreneur thinking “we will get funding by then”. Even with funding it often remains a personal debt as VC does not want to pay pre operating expenses occured by the founders as this is sweat equity and skin in the game etc. In the big GDP picture this is a rounding error, but in our innovation economy this is a big deal

  3. Kenosha_Kid

    Isn’t a VC’s liquidation preference sort of like debt from the entrepreneur’s perspective? And isn’t the Internet taking costs out of the system, as you put it, an absence of revenue that is a capital drain from the VC’s perspective?Maybe the ray of light is instead in the very fact that capital providers will be less likely to inflate another bubble any time soon. While bubbles may have provided short-term gratification for some, in the long term these have been very damaging, on multiple levels. Maybe there is something to be said for an environment without frenzy and hype, and maybe it will be a good thing to get back to fundamentals.

    1. fredwilson

      A liquidation preference doesn’t have to be serviced like debt, there’s no term, and there are no covenants to worry about breaking

      1. Kenosha_Kid

        True enough. The similarity, however, is in the sense that the first value creation goes to pay off the liquidation preference, like debt, before the entrepreneur sees any return. And while there isn’t a term, the timing of exit is often out of the entrepreneur’s control. A truer equity sponsorship would probably be one in which the founder’s equity and VC equity all hold the same class of securities, ideally common. But I understand the original point about VC not relying on financial leverage. I’m only suggesting that it’s sometimes a relative thing.

        1. fredwilson

          Well entrepreneurs control the exit timing so its only fair for VCs to get their money out first

          1. Steven Kane

            in what sense do entrepreneurs control the exit timing fred?sure, in some cases (though pretty rare) an entreprenuer will de facto vetroi an exit by saying, hell no I won’t go. which, if the founder is key personnel, means no dealbut how often does that happen? much more often the founder(s) are earning very very little present value compensation (e.g. salary) and will want to go back to the startup well so will be terrified of alienating VCs so whatever the VC wants, gets donealso, as you know, as a practical and contractual matter, the preferred shareholders have the absolute irrevocable right to liquidate the company, whether or not foundesr or common sharegholders agree or disagreemost likely if there is actually strong disagreement between foundesr and VCs then VCs will find a way to remove founders well before they could interfere with an exit opportunity that preferred shareholdesr like. this is very common, no – that founders are replaced with journeymen management teams? and management for hire is much much much less likely to be in a position to debate (let alone block) an exit?

          2. fredwilson

            I don’t know what world you are living in steve, but it’s not mineI am struggling to think of an exit I’ve been involved with in the past 10 years (there has to be one but I can’t think of it) where the VCs drove the exit. It almost always is the entrepreneurs who decide its time to exit, including your sale of gamesville to Lycos.The truth is you can’t sell a company without the management being excited about it. the management has to go with the deal and the VCs don’t. so the idea that the VCs can force the management to sell is just not accurate.And VCs have an incentive to hold out for the biggest win, so forcing a quick sale of the company isn’t in our interest. But if management says to us, “it’s time to sell” then it’s crazy for us to block a sale.Sure we could have gotten in the way of many of the early exits in our portfolio and some would say we should have. But as the saying goes in the VC business, “when management wants to leave, they know something you don’t”.

          3. Chris

            Steve does have a point. A company I founded was offered $55M and the Board voted to block it (control by VC). As a result of walking away from the deal the company had to raise additional vc capital and the common shareholders paid an ugly dilution price. Though the company is still doing well it will take an exit of $150M+ to get the same payout for the founders and angel investors.This got very ugly internally where the founders considered exploring legal action.Lesson learned – pick your VC’s wisely.

          4. fredwilson

            That’s an uglyl story and I sure hope it ends well for you and your co-founders

          5. Steven Kane

            Fred, as to the world you are living in, well, I think you are anexceptional investor and individual ‹ and by exceptional I mean not just inthe colloquial sense but also in the strict sense of the word, meaning, theexception. Your experience, attitude, sense of fairness and long-term viewof your work and relationships are not all that common, at least in myexperience.As for the world I live in… well, I’m not sure where you and I disagree.When it comes to exits (and other things) naturally, management views mayprevail.But VC views always prevail.Sometimes all are in agreement, of course. But if there are differing views,preferred shareholders always carry the day.That’s one of the most basic, foundation-level terms in every VC funding…isn’t it?I’m not saying its fair or unfair. It’s neither. It simply… is.That definitely was the case at Gamesville. Yes, my cofounders and I wereexcited to exit Gamesville and argued for it, successfully. But the VCscertainly could have blocked it. And Fred you weren’t there so perhaps youdon’t know, but some wanted to. There was a spirited discussion aboutwhether or not to sell to Lycos ‹ because of a hope for even higher returnssomewhere down the road. In the end I had to make an impassioned argument,pointing out that while VCs manage portfolios and get many, many bites atthe apple year in and year out, we entrepreneurs are lucky if we do two orthree deals in our entire careers etc.And all that, despite that the preferred shareholders were making 5X returnin only 5 months! (The company was 6 years old but only sold preferredshares 5 months before the Lycos offer.)Again, I’m not saying anything was/is right or wrong, fair or unfair. Justreality.I mean, imagine a scenario where after a bunch of years of slogging it out,the entrepreneur wants to exit as he/she will make what he/she considers abig payday but the VCs see it only as a ³double² and so want to keepplaying for several more years to go after the ³home run². Both sides areperfectly in earnest. And I wager in some such situations the entrepreneurdoes not carry the day.Etc…Mind you, I’m not saying there aren’t equally tough situations where the VCsgo against their better judgment and go along with entrepreneur (and maybelater regret it.) Happens all the time.But I still have to respectfully differ with your suggestion thatentrepreneurs or management somehow always gets their way. No, they carrythe day when preferred shareholders agree. And they do not when preferredshareholders disagree. Its just the simple basic contractual setup.No?Any case, for me anyway, the bottom line is that, the fact that there aremagnanimous investors like you, Fred, should not distract entrepreneurs fromconsidering that other investors may view them less amiably, perhaps evenlike a commodity.And that it is entirely possible ‹ maybe likely — for common shareholders’and preferred shareholders’ interests to diverge, given time and engineeringof preferences and the cap table.And that entrepreneurs have an obligation (to themselves!) to understandwhat the terms in the term sheet really mean — over time and under stress– and fully understand who actually controls what and when and under whatconditions and at what cost, etc, and never assume that investors rights donot have very, very practical ramifications…This doesn’t mean entrepreneurs and VCs need to have some kind ofantagonistic or adversarial relationship. Not at all! Like any businessrelationship ‹ and it is a business relationship — it will bemulti-dimensional, and vary a lot over time.So then — all I’m trying to say is just some simple common sense advice toentrepreneurs, as was so artfully expressed in the opening scene in AnimalHouse:³Knowledge is good.²

          6. fredwilson

            Well this is a question of whose experience we are using to determine the right answer. All I am saying is that I have consented to many founder driven exits that did nothing for me and my lpsI did that because I believe the entrepreneurs have all the leverage in the venture ecosystem and you cannot get on the wrong side of entrepreneurs or you’ll never see another good deal come your wayYou see it the other way. Fred

          7. Steven Kane

            Bless you, my man.

  4. Josh

    Fred,Not to turn this into a political discussion, but given your post on this subject, why is it a good idea to raise the capital gains tax?Obama wants to make it more progressive, but I am of the opinion this is purely for class warfare reasons and to raise some near term revenue for spending increases. The same seems to be true with wanting to raise the death/estate tax (proven by several studies to cost more to collect than all the funds it brings in), and raising high income earner federal tax rate.Wouldn’t it be wise to incentivize people to innovate and create wealth instead of the disincentives mentioned above? It seems current monetary policy is doing all it can at this point. The strong dollar is helping importers (hurting exporters). But, Obama’s tax plans seems to mimic the mistake Japan made at the height of their crisis during the mid-90’s (raising taxes). Curious to hear what you think…

    1. fredwilson

      If you really want to mess with the tax system, eliminate deductibility of interest on debt and then we won’t get into this mess againI am not sure you can do that right now, too many consequences

  5. Tom Hughes

    I’m sure you mean for this to be read in conjunction with “Hacking Education,” your previous post. The deleveraging will be difficult, especially for incumbent institutions like big banks and brokers whose margins in the now-defunct bull market were multiplied by borrowing. The key thing, it seems to me, is to firewall the banking-system meltdown so it doesn’t impact investment in human capital, which will be the indispensable asset for the next cycle of economic growth.What does that “firewall” look like? Well, we should make sure grade-schools and high schools get what they need, even at the expense of other priorities (will we choose protecting education over, say, rescuing the over-mortgaged? tough choice). And we should do more to promote competition among education providers at all levels. With the likely change of administrations, there is a risk that the national and local education bureaucracies will just be “spoils” for newly-empowered interest groups to fight over.` Our leaders (whoever they are) will need strong signals from us that this is not something we can trust to vested interests protecting their legacy entitlements, whether that is teachers’ unions or textbook publishers.This will be a long period of global competition. China and India, essentially free of the burdens of powerful bankers and their lobbyists, have a potential advantage here. We could spend the next decade in backwards-looking “bailout” mode (what Japan did in the 1990’s) while our competitors are in “leapfrog” mode. Our strongest advantages? A vibrant democracy, a long-standing guarantee of free speech, and a merit-based competitive market for human talent.Fred, thanks as always for raising the critical issues that connect business and global politics. It gives us all hope!

  6. Wallen's

    Spot on Fred! The question is whether this recession will be a “U” shape or a “L” shape (“V” shape being out, of course). The difference between the two will come in part from public economic and monetary policies and avoiding the Japanese mistakes (the Nikkei is at a 26 years low!!!). On another angle, the US has usually been a locomotive for EU economies. This time maybe it will be the other way around as leverage in Europe is much lower than in the US (except for the UK and The Netherlands).

  7. Brett Tilford

    Unique insight on the financial crisis. I think that most people are focused on the private sector and the problems that got us into this mess but I agree that the debts in the commercial sector are just as huge. Many of the individuals in personal financial trouble are small business owners in corporate trouble.

  8. earnwhatyouspend

    This couldn’t be more spot on – it’s pretty scary what is happening out there in the consumer credit markets. Paul Krugman wrote about the paradox of thrift last week – where when faced with a situation like this, consumers need to reduce their spending, but the very act of doing so has negative consequences on the economy…

  9. Patrick

    So isn’t now the time to start cherry picking stocks with low debt/equity ratios?

  10. Brian

    Hmmmm ….I am assuming this is just the total amount of the mortgage debt in red. This seems to just be tracking the increase in home prices.I wonder what this chart will look like when all those people who bought homes that should not have been allowed to borrow have their debts written off the books. I would guess the red is knocked down a lot.Remember, not all the debt needs to be paid off to lower the % of household income in mortgage debt.

    1. fredwilson

      Yup. I made that point in the post. Foreclosure and liquidation will make this go down

  11. howardlindzon

    simple, to the point. sad but true.

  12. Dan

    fred,you said “VC does not rely on leverage.” are you sure?check this. VCs that are any good generally have institutional LPs. institutions have asset class caps. denominator effect resulting from significant losses from other leveraged asset classes forces institutions to rebalance. institutions will be forced to evaluate invested and pending commitments vs their perception of a VC’s performance. VCs that underperform in this analysis will get defaulted on or have their LP’s stakes sold in the secondary market. With big institutions looking to sell significant volume in the secondary market and VC portfolio NAVs not yet marked down to reflect the recent economic collapse no one will buy anything in the secondary without a massive discount to NAV. This makes the default scenario more likely. Once this happens VCs have less available for the follow-on investments you planned for previously. Without exits and with valuations driven lower by the falling public markets this compounds a VC’s problems. Now portfolio’s must be trimmed and portfolio companies find themselves getting shut down.VC still doesn’t rely on leverage?

    1. fredwilson

      That’s a second or third order effect at best. Everything relies on everything by your logic which I don’t argue withBut venture capital is one of the least debt reliant/affected sectors of the economyAnd I think you overstate the lp default issue. We are not seeing it in our funds. In fact we have lps licking their chops at the oppty to pick up any lp interests in our funds if they come available. We’ve already received four inbound requests on that in the past couple weeks

      1. Dan Cornish

        VC is debt. Holders of preferred shares can redeem their stock after a certain period of time and typically there is a dividend(interest) associated to it. When a VC fund has reached its end, usually after 10 years, the money has to be returned to the investors. Companies who do not have a prospect of a liquidity event have a time bomb ticking they have not thought about for a while. I suggest that many companies will have preferred share holders start to ask for redemptions in te next couple of years.

        1. fredwilson

          The redemption provisons are not standard in most ventre deals these days. I’d say we see them in less than half of our deals and in 22 yrs I have only seen one redemption out of hundreds used

          1. Dan Cornish

            Thanks for the clarification. I personally know of a few companies which have faced this. What is your decision point wether to include redemption or not in a term sheet?

          2. fredwilson

            We ask for it but we don’t really fight for itI have personally never asked to be redeemed even when it was available to meThink about it, you’d have to be certain that you’d never get more than your money back if you chose redemption and I like the optionality of upside, particularly on a deal that is 5-7 years old and still in business