Would Stress Test Assumptions Hold Up For A Startup?

Posted by: John Tozzi on May 8, 2009

Entrepreneurs are sometimes accused of seeing the world through rose-tinted glasses. They’re too optimistic — naive, even — about how quickly they’ll be profitable and how fast their companies will grow. Lenders and investors wisely view projections in business plans with a skeptical eye. Young companies trying to raise capital based on hopeful projections probably won’t have much luck, especially in this economy.

The same may not apply to the nation’s biggest banks, 10 of which need to raise a total of $75 billion in the next six months. That’s what the Fed determined after running the stress tests intended to see how the financial giants would hold up if the economy deteriorates further. But are even the Fed’s “adverse” projections too rosy?

As Conor Clarke at the Atlantic points out, the actual economy is “evolving in lockstep with the adverse scenario. Or maybe it’s a little worse.”

This was an early criticism of the stress tests, but it really is striking. The adverse scenario assumes 8.9% unemployment, which is the rate the Bureau of Labor Statistics announced this morning. They assume -3.3% GDP growth for 2009; the annualized rate for the first quarter was -6.1%. And they assume housing prices will drop 22% this year; the latest S&P/Case Shiller Index shows year-over-year declines nearing 19%.

How would the Fed’s “adverse scenario” projections hold up to the scrutiny of a venture capitalist? Shoring up huge banks is, of course, quite different from funding startups. But with that caveat, I asked some VCs to evaluate the stress test process the same way they’d look at a startup’s projections.

“I look at the macroeconomic data and it does seem in the zone of realism that these projections could be right,” says Dan Rosen, principal at Highland Capital Partners in Boston. Rosen did say he was concerned that there appeared to be a “negotiated opinion” between the banks and the government on what the stress tests would show. But while the assumptions may not be unrealistic, he says, he’d want to run more rigorous tests if it was his money on the line. “To some extent, I’d be pretty skeptical if these were guys coming into my office, just because we’re always skeptical.”

Ullas Naik, managing director of Globespan Capital Partners in Palo Alto, also gave regulators the benefit of the doubt. “The process was not necessarily flawed. You could always question [the assumptions.] Hindsight is 20-20. They were also operating in a very fluid and very dynamic and very panicked environment,” he says. “Had I been doing that, perhaps I might have taken a more aggressive approach,” but Naik cuts the Fed some slack because they had to make assumptions about the economy in a highly uncertain situation.

Not everyone was so sympathetic. Michael Greeley, general partner at Flybridge Capital Partners in Boston, called the Fed’s assumptions “borderline irresponsible.” Says Greeley: “I find the assumptions to be on the margin pretty optimistic. If nothing else, we’re in an environment we’ve never seen before, so how can you err on the side of being too optimistic?” He acknowledged that a true worst-case evaluation could cause a panic that would be a self-fulfilling prophecy, but he also worried about the credibility of regulators’ if their projections don’t hold up. When portfolio companies are too optimistic, he says, VCs bluntly tell them their projections are not responsible. And if it’s a chronic problem, says Greeley, there are consequences: “If a CEO continually misreads the market, you end up more often than not replacing the CEO.”

Reader Comments

Victor Cheng

May 13, 2009 2:09 AM

The old adage plan for the worst, hope for the best is a good one.

Unfortunately, in the case of the stress test for the banks, it's plan for the best, and hope for even better.

Given we've gone way paste the test scenario, the test loses a lot of its value.

In terms of startup companies, you most definitely want to make sure the business is viable in an extended downturn.

Given the level of US Debt (Government, corporate, and consumer) express as a percentage of US GDP is nearly double that of the peak of the Great Depression and the highest in recorded history... and given the deficit spending of this year and Obama's stimulus package, it's safe to say our economy will be highly uncertain for many years to come.

Whether it's one long recession, a back-to-back one, a recession followed by hyper inflation, or any number of scenarios, "uncertain" is the new normal.

If you want to start a business in this environment, make sure it can work in the "new normal".

Victor Cheng
Author, The Recession-Proof Busienss
www.victorcheng.com

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About

What's it like to run your own company today? Entrepreneurs face multiple hurdles new and old, from raising capital and managing employees to keeping up with technology and competing in a global marketplace. In this blog, the Small Business channel's John Tozzi and Nick Leiber discuss the news, trends, and ideas that matter to small business owners. Follow them on Twitter @newentrepreneur.

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