Private capital’s pipeline to startups can be in trouble
We are living in extra ordinary times when speaking in macro terms, we had once in a century pandemic followed up with the first large scale war in Europe post WW II. And economically speaking, we are coming to an end to the extra ordinary measures undertaken by Federal Reserve (Fed) post Global Financial Crisis (GFC) which has resulted in zero nominal interest rates and trillion dollars of liquidity in the market.
Looking back…
The last decade has been extremely good for startups, from barely one unicorn in 2007 we have seen a record breaking 529 startups becoming unicorns in 2021. This phenomenal growth has resulted in tremendous business innovation and more importantly wealth creation to founders, employees and investors alike. Together they represent nearly $ 3 trillion wealth creation globally.
This is not restricted to startups alone, we have seen increase in valuation across asset classes. Equity assets have grown with S&P 500 index growing from the lows of~800 in 2009 to the highs of ~4500 in early 2022, resulting in CAGR of 14.4%. This is higher than the 12.4% growth between dotcom bubble and GFC. This has primarily been driven the unorthodox monetary policies employed by the major central banks of the world (Fed, ECB, BoE and BoJ), including near 0 nominal interest rates and injection of trillions of dollars of liquidity via Quantitative Easing (QE).
Central bank policies have contributed to the inflated valuations in multiple ways
- Near 0 interest rates has spurred investors to find alternate assets which provide positive returns. This has resulted in crowding in of investments into equity managed investors look for positive returns to hit their target return rates on portfolios.
- Low benchmark rates would result in higher valuation by the Discounted Cash Flow method as the lower hurdle rates significantly boosts the value of future cash flows
- High liquidity allows traders and investors (Hedge funds, etc) to lever up and take long positions
- Low benchmark rates have enabled companies to take on debt, initiate share buybacks resulting in higher share valuations.
The affects are not limited to equity valuations, but have spread across other asset classes including Real estate (record home equity value across US, Canada, Australia, New Zealand and others) and more speculative investments like Crypto assets.
And this has definitely impacted startup valuations. When valuations of comparable companies soar, the multiplier for a startup in same space increases. Low interest rates have spurred investors to divert higher share of their investments towards high yielding but riskier bets like startups. Nothing illustrates this better than the humungous Vision fund from Softbank with a total fund size of $ 100 Billion.
What next…
As I have in the beginning, we are living in unprecedented times. Multiple waves of the pandemic coupled with the disruptions due to Russian invasion of Ukraine is creating mayhem in the world. Decades of disinflationary pressure from cheap Chinese labor is coming to an end with supply chain disruptions exacerbating the same. Inflation is running rampant across the globe with the major western economies seeing inflation that is typically seen in the emerging world.
This has forced the central banks to step back from their unconventional monetary policies. US Fed has already initiated the path away from near 0 interest rates with periodic rate hikes and indicated that they will bring interest rates to perceived “neutral rate” of 2.5% in the next few years. The path could include higher than neutral rate in the intermediate with some forecasting rates at the range of 3–3.5% in 2023–24. Fed has also indicated that they will move away from QE and move towards QT (Quantitative Tightening) and instead of asset purchases, it will look to shrink the size of its balance sheet.
All this blows a huge puncture to incredible valuations across asset classes including equity. The equity markets have already seen the impact with S&P 500 losing more than 20% from the start of the year. But most metrics suggest that equity valuations have not yet seen the bottom of this cycle. (Here is an excellent compilation across various indicators which show that the recent bear market has not reached its bottom). The cyclically-adjusted price/earnings ratio on stocks was higher than in any period since 1881, except for the late 1990s and early 2000.
Lets come to startups..
Startups like all growth companies’ valuations are immensely susceptible to interest rates. Higher the interest rate, the lower the present value of future cash flow, given the higher uncertainty of those cash flows. This can already be seen how stocks like Tesla has lost nearly half its value from its peak earlier this year. Hence the riskier the asset, the greater should be its fall in value when interest rate hikes are considered.
Additionally when you consider first principles, a value associated with an asset is proportional to the income it generates. When you apply this principle to an nation’s economy you get buffet indicator — The ratio of the stock market’s total market capitalization to GDP — At May’s market low, the Buffett Indicator was 145% higher than at the average of past bear-market lows, and at the 95th percentile of the historical distribution.
Now ideally you should include the valuations of private companies which have exploded since GFC, with more than 600 unicorns in US with a combined valuation of $ 2 trillion, nearly 4% of the total US public market capitalization. This excludes startups that are yet to reach unicorn stage. Hence the current valuations across the startup space is untenable in most cases with higher interest rates leading to steeper discounts.
Refinitiv’s venture capital index, which uses the performance of individual VC portfolios and listed stocks to mimic the performance of the broader industry, tanked another 24.2 per cent in April, taking its 2022 loss to a comically bad 45.8 per cent (NB, the Nasdaq is “only” down 19.7 per cent YTD). That is comfortably its worst monthly performance since worst of the dotcom bust two decades ago.
As MOHAMED EL-ERIAN pointed out — Private equity is just as likely to experience a shift in operating paradigm this year as the public markets have been undergoing. What lies ahead is a world in which the cost of money will be higher and financial flows more selective as they become less ample.
More importantly, this valuation discounting will hit the funding pipeline of the startup industry. Majority of the startups are not profitable and hence need funding to maintain cashflows and operations. Hence they are forced to go to frequent fund raises. Now the discounted valuations means the existing investors will be forced to take hair cuts of their previous investments.
Additionally a bear market would all but cut-off the exit via public markets or IPO. Even if few startups would dare to attempt, subsequent price declines might make it costly for investors. One can look at the share prices of Rivian, Coinbase and others.
And what is more important is that unlike previous dips, there is a high likelihood that equity valuations will not go back to the previous peaks very soon. It took nearly 6 years for S&P 500 to reach its pre-GFC peak after the financial crisis [S&P hit a peak of 1500+ in Oct 2007 and was able to hit the same peak again in Mar 2013]. Hence equity valuation can stay depressed for long time. With the market at 20% decline still having room further declines, it can be a very long climb back to 2020s peaks.
All this means, it will be very hard for VCs to find good exits to their existing investments done at the peak of QE. As VC funds begin write down their stake in existing investments (like Tiger VC funds write down of Bytedance), they will be forced to take losses on to their fund. This means it will become harder to raise new funds and more importantly there will be lesser appetite for new investments.
Late stage VC funds will be the first to be hit with large sums invested and these investment being in the recent past, the investments will be at high valuation which cannot be sustained currently. Their investments will be forced to take losses as the large stage startups new rounds of funding via private or public capital will be at high discounts. And with very low chance of returns to previous peak in next 6–8 years, these funds will find it harder to turn it around (given typical fund duration of 7–10 years).
Now this will reverberate across the funding funnel, the current exist strategy of earlier funds would be get later stage VC funds invested in your startup. Crisis in Late stage funding would mean, Series B funds will find it harder to help their startups sustain. They will not have the wherewithal with the funding to support on their own. The lack of funding later in the funnel would mean a lot of their present investments might be forced to shutter down.
And as Abraham Thomas notes in his substack described as “Minsky Moment in Venture Capital”, startups might not only need to cope with valuation spiral but also the accompanying talent spiral.
This would repeat similarly across the funnel from Series A funds to Early stage funds and finally angel investing. All these without taking into account potential black swans or grey rhinos in the coming years and there are many — Escalation in Ukraine crisis, Crisis in Taiwan straits, Market crash induced by Crypto (like in case of Tether taking the Terra route) or broader slowdown in the Chinese economy — Any of these events can make the recent bear market look like a cub in comparison.
As Abraham Thomas concludes in his substack.
If compressed timelines are the driver of Minsky inflows into venture, then anything that delays funding cycles could precipitate a painful reversal. First some startups delay fund-raising because they need to grow into their valuations; then the VCs who invested in those startups have to delay their own fund-raising with LPs because they don’t have the requisite markups; then the LPs reconsider their (hitherto ever-increasing) allocations to venture because the latest returns are uninspiring; and before you know it, there’s an exodus from the asset class. Minsky giveth, and Minsky taketh away.
What should startups do…
It is going to be very difficult for any startup to pass through these turbulent times. The high level uncertainty and the varied trajectory the global economy can take in the next few years makes predicting and planning almost an futile exercise. But there are few things
- The fast and compressed timelines in growth in valuation will become difficult. A soonicorn expecting to turn unicorn in next year might have to wait for 2–4 years for the same. Even companies exhibiting good growth might have to be contend with fund infusion at the previous valuation.
- India unlike US has seen 2/3 startup downturns in the last decade and in all of them things turned around in 1–2 years. Hence a runway of 1–2 years was deemed sufficient to wither such storms. But given the larger uncertainties now, startups would need to think of longer runways of 3–5 years as new rounds of funding become scarcer. It is better to plan for the worst giving more flexibility.
- Talent management is critical, with increased cost pressures and slow growth in value of stock options, firms need to ensure they are able to motivate and retain the right talent through the downturn. More than funding, a talent down spiral can lead to a death of even good startups with valid business models.
- Focus and Execution will remain the key, too many startups in the recent past have tried to be many things to many people. While Indian is filled with opportunities and it is tempting to exploit as many as possible, now is the time for founders to narrow down and focus on delivering the key value proposition of their startup
- Revaluation of the potential market. India with a billion people, the estimated market size and opportunity always looks large on paper. Startups should revaluate the real size of the user base who can afford to use their offering. User acquisitions at all costs should no longer be the mantra and focus should be on core users and deriving value from them.
The above pointers are mostly obvious and I am not stating something that is not widely know. It is always easy to analyze in retrospect and almost impossible to predict how the future unfolds. I would not envy the positions founders and startups are in the times of uncertainty. All I can do is wish them Good luck and hope the future is sunnier than the dark clouds portend for now.
And finally, as Vincent Mortier of Amundi Asset Management recently likened parts of the private equity industry to a “Ponzi scheme”. VC funds across the funnel have played along the valuation game by passing the parcel to one another and jumping valuation at each stage. Now that the music has stopped, it would seem that everyone could be holding the bag.
