Bullish Startup Market Losing its Horns
Issue 6 (20/05/2022) - An Article connecting the Federal Reserve and Macroeconomic trends to the Startup ecosystem and how this affects raising money, startup runways, and the market as a whole
Hi everyone, apologies for the late publication. I am a year and a few months late with this article but here is a solid effort to bring it back. Hope this is worth the 1-year hiatus and all the supposed learning I did in the last 2 semesters of college…
Introduction
The end of 2020 saw a meteoric rise for IPOs, from Airbnb and Palantir to Snowflake and Doordash all trading at valuations that remained arguably inflated compared to true estimates. This era spilled over to 2021, even though inflation soared and the economy faced supply chain issues and significant labor shortages. In totality, roughly 400 private companies raised over $142 billion in the U.S. stock exchange by December. However, a bullish economy that seemed to have rebounded after the pandemic may soon lose its horns.
Figure 1: S&P 500 nearing the Bear-market threshold. Source: FactSet, Presented by the Wall Street Journal in “Stock Markets Finish Volatile Session Lower as S&P 500 Extends Decline”
Both the U.S. stock and bond yields, as well as the S&P 500, have fallen significantly with the latter “flirting with a bear market”. Now to economists, this makes a lot of sense, but what in the world does “flirting with a bear market” even mean? Basically, it is a fancy term to indicate that the index has seen a drop of 20% from a recent high, implying that we are coming close to a recessionary period. [NOTE AS OF 20/05/2022 IT HIT IT].
But why is this important? So what if the stock market is having a little bit of a tantrum? Why does it affect startups? This is where macroeconomic theory closely tangos with traditional microeconomic concepts… I’ll try to keep this section to a minimum to make space for all the good stuff. When the economy isn’t performing too well, especially with indexes such as the S&P 500, investors grow more uncertain about asset pricing, and company valuations, and weigh risk more heavily under a volatile market. This in turn makes VCs more skeptical about their investments in startups, whether that is funding for a Series round or an IPO. More importantly, the dichotomy between the markets slowing down and the premature expansion of many VC-backed tech companies created an interesting scenario, where companies over-expensed on employees wasting money whilst the economic demand for said employees continues to decrease due to market trends. So… this article flirts with the idea of falling market trends as well as inflated tech company bubbles that are slowly bursting - and perhaps more importantly, how the relationship between the two has turned a little sour.
Reasons for Falling Global Markets
I’m going to bullet point why the global markets are falling, AS I DO NOT WANT that to be the focus of the article, but rather the ramifications it has upon startups:
Investors projected an impending recession and grow continually anxious about the outlook
Russian War encroached on the economy at a time when it was still bouncing back from the pandemic
Sanctions coupled with supply chain disruptions affecting the price of commodities such as oil, iron, and fertilizer
Russian war doubling down on anxious outlook upon the consumer economy
Chinese lockdowns amplify supply chain shocks that reverberate through the global economy
Hopefully, that is enough to convince you of the falling global markets…
Figure 2: Image of a Bull, because I felt like it…
How are these Impacting Startups?
Y Combinator informed startups to “plan for the worst” after noticing this 13-year bullish market starting to lose its traction. YC encourages companies to either wait to raise money or if they do not default alive, to raise money asap to get there. “Default Alive”, is a term coined by Paul Graham stating that after a company has been running for a certain period of time, are they able to reach a profit making stage with the current runway of cash they have remaining.
To note, currently the U.S. Federal Reserve is moderating inflation and unemployment by manipulating the money supply. In 2020, as a response to the pandemic, the Reserve “pumped a substantial amount of money into the economy”, through means such as bonds. The Government bought treasury and corporate bonds, enabling many bondholders to receive a lot of liquidity. These investments ventured into real estate, and stocks, but also a segment of the windfall went to VCs. This is no longer the case anymore, which is partially the reason for the impending problems.
What Should Startups Do?
Honestly? I’m not a VC-Backed founder nor am I an industry expert. I’m just a college student with an average GPA with an above-average interest in startups. So here are my two cents, but make sure to take it with a grain of salt.
Extending Runways
Startups remain strapped for cash and keeping their money in their pockets remains as important as ever. What companies should focus on right now, especially ones that have not been raised yet, or are looking to raise soon is to not reach “the fatal pinch”, as termed by Paul Graham. You cannot maintain the trichotomy of being default dead, facing slow growth, and not having enough time to turn it around.
Only in the case that doesn’t have runways to reach default alive, should the companies consider beginning raising money. Yes, certain companies are still raising money at consistent and commendable valuations, but the understanding is that the near future remains bleak. All the money already committed will be provided to startups; however, newer investments to previously uninvested companies may begin to reduce.
On the topic of extending runways, I’m sure you have heard of companies such as Peloton and Robinhood laying off people in their company in recent weeks. These all are forms of extending runways to last longer as well as cutting dead weight to increase efficiencies in companies. By the time of writing this, we have seen 3 solid weeks of tech layoffs with little to no sight of change. Certain startups such as “Section4, Carvana, DataRobot, Mural, Robinhood, On Deck, Thrasio, [and] MainStreet” have seen a reduction in their workforce. Larger companies such as Twitter and Meta are instituting a hiring freeze, similar to what Uber has done previously. Essentially, tech companies are doubling down on extending runways and increasing efficiency.
Even companies that recently hit unicorn status are not getting away, such as Picsart which raised $130M from Softbank at a $1B+ valuation, and had to lay off 8% of its employees. Similarly, the problem isn’t only impacting American-based companies as India’s Cars24 had to cut 6% of its team as a Series G startup.
Expecting Downrounds
YC advisers explained in their note to their startups that if they do not have a runway, they may have to consider raising money - but this has its sets of caveats as well. YC explains that:
“If your plan is to raise money in the next 6-12 months, you might be raising at the peak of the downturn. Remember that your chances of success are extremely low even if your company is doing well.”
We may not see IPOs and Venture Rounds at astronomical rates nor at sky-high valuations compared to those we are used to seeing at the turn of 2020. I believe there are a few reasons for this: less cash, less competition, and flight of quality
Less Cash
There is less cash to go around, so VCs aren’t lining up to line the pockets of startups, especially ones that have not been previously backed. This also implies that the venture rounds that do go through tend to be at either lower valuations, or lower sums of money - both of which mean less runway for startups.
Less Competition
This is a simple demand and supply conundrum. There are fewer VCs who are willing to invest in startups, not currently, but the trends suggest such. This means that there will be less frequent bidding wars over hot commodity startups which means lower valuation investments that potentially may reach down rounds.
Flight of Quality
Companies with the product-market fit, a balanced value chain, or a lower risk asset may see little to no changes in their investment expectations. VCs will slowly become a lot safer with their investments, which means greater scrutiny upon the quality of startups, the quality of the team, and most importantly, the financials and runway that the companies can maintain. This is known as the “Flight of Quality”.
Final Remarks
So.. this is the thought of a rising Junior in college, so please please please do take this with a heavy hand of salt. I mean one of those costco-sized salt packets because I promise you, this is more my thoughts of market trends with some seasoning of fact, instead of the other way around.
The global economy does see many signs that may lead to a recessionary mindset, and of course, this shall affect startups as well. However, with the bubble that we have been living in with regards to startups and investments, it feels as if we have a protective layer covering the industry from macroeconomic trends. My thoughts remain a tad more skeptical, with of course the hope to revert back to investments as grand as Airbnb and Doordash because who doesn’t love reading about that…
Bibliography
https://fortune.com/2021/12/24/2021-ipo-boom-ending-2022-outlook/
https://www.wsj.com/articles/global-stocks-markets-dow-update-05-19-2022-11652941326
https://techcrunch.com/2022/05/16/how-quickly-are-startup-layoffs-accelerating/
https://techcrunch.com/2022/05/11/tech-layoffs-dont-happen-to-companies-they-happen-to-people/
https://techcrunch.com/2022/05/07/the-great-resignation-meet-the-great-reset/
https://techcrunch.com/2022/05/19/yc-advises-founders-to-plan-for-the-worst/
https://techcrunch.com/2022/05/20/startup-tech-layoff-may-week-3/
https://www.axios.com/pro/climate-deals/2022/05/20/colossus-layoffs-energy-software-startup
https://inc42.com/features/over-5600-employees-impacted-in-indian-startup-layoffs/