The best startup investing opportunities come in bad times
The Great Recession of 2007 resulted in some of the best venture capital vintage years in modern history. Many of the world’s most respected VCs earned their reputation from their investments during that time.
Big shocks to the economy often result in new opportunities for unique business ideas. VCs who invested during that time were able to capitalize on the macroeconomic conditions which led to a shift in consumer behavior while founders were fired up to create innovative products and services.
Many of the companies they funded during that time went on to become highly successful, multibillion-dollar publicly traded companies over the following decade, such as WhatsApp, Slack, Uber, Pinterest, Square, Instagram, and more. The returns they made are some of the biggest in history, proving that a downturn is one of the best times to take advantage of the market.
The Current Climate
Venture capital has delivered the highest long-term returns among major asset classes in the last two decades. Data from Cambridge Associates shows that the venture capital asset class produced an annualized return of 20.5% for the period from 1995 to 2019, which is higher than the returns of public equities (8.2%), private equity (11.9%), and real estate (8.7%). Some of the top performing venture capital vintages have come from or right after tense economic conditions (for example, 2008-2012). This happened after the dot-com bust but even more so after the Great Recession in 2007.
Many economists are predicting that the current economic downturn could last through 2024, which could present an opportunity for venture capitalists with large funds and a lot of "dry powder" to invest in startups at discounted valuations. As startup valuations have come down from the highs of recent years, this could be an opportunity to make large investments in companies that have the potential to be massive home runs over the next decade.
Bill Gurley, a well-known venture capitalist, recently stated in a podcast interview that despite the current economic uncertainty and market challenges, now is a great time to invest or start a company. During economic downturns, established companies are more focused on cost-cutting and survival, providing an opportunity for new startups to gain a foothold in the market.
History tends to repeat itself, and there’s no reason that this time it will be any different. Volatility and risk are opportunities for investors. Venture capital is based on investing on long-term horizons in companies that have the potential to shift paradigms, so investing during downturns when valuations are lower can provide an opportunity to generate accelerated returns.
“Many funds and many startups will fail, but those that are able to position themselves well into this coming cycle will be the next a16zs and Sequoias.” - Marc Schröder, managing partner and co-founder of MGV.
Market Downturns are a Golden Time for Investing
Economic conditions are not tied to a startup’s success
First off, economic conditions are not what makes a startup successful. Sure, it may be harder to raise money during turmoil, but what makes a company successful is the strength of the team, the vision of the founder, and the quality of the idea. Startups have no control over macroeconomic conditions so it’s not something that dictates whether they should do business or not.
Winners and innovation are founded across all market cycles, as we’ve seen with Uber, Square, WhatsApp, Airbnb, PayPal, and many others that were started during recessionary environments. Companies that are more focused on capital efficiency during and after a recession can create stronger business. When times are good and capital is freely available, there’s a lack of respect for it with lack of attention to gross margins. But in a downturn, a lot of these bad practices are simply not sustainable, forcing founders to really hone in on what matters.
Less competition
When there’s less access to capital, there’s also less distractions and less competition. Funding scarcity can be a blessing in disguise as startups aren’t competing with 50 other copycats all building on the same idea for the same market, and no one is competing to “raise more money” because their competitor happened to raise $50 million.
When there’s fewer dollars going around, the quality of companies receiving funds is also much higher. From a VC perspective, VCs are also forced to do more thorough due diligence as deal flow declines.
Access to top talent
Talent is part of what makes a truly great product, and those who survive the downturn with the best talent will be the true winners.
When the labor market becomes challenged, it is one of the best times for startups to form the strongest teams, ones that will ride with you through the desert and carry on even when there’s no water to be seen, because they believe that water will emerge somewhere along the horizon. That’s what a strong team is all about.
According to Crunchbase, more than 46,000 employees in the etch sector have been laid off so far in 2023 , which means that the crème de la crème are now on the market, ready for the taking. The ones who would usually be taking positions at a FAANG are now available for the taking at early-stage startups.
Not only that, but with remote work now being more popular than ever before, it is a huge advantage to employers who want to tap into a global pool of talent. Remote work allows flexibility and access to talent founders might otherwise miss.
Lower valuations are a positive for investors
As Warren Buffett once said: “Be greedy when others are fearful.” The current market environment certainly reflects the opportunities Buffet was referring to.
Startup valuations come down drastically during a macro-economic climate, so investors can invest at lower entry point valuations. This is a huge net positive because these assets are held for at least 5 to 7 years, so by the time investors exit these startups the economy will have rebounded, and the results will be better than if there had been no economic downturn.
Even though in a boom economy VCs can generate strong returns as valuations are rising quickly and there is a robust secondary market for partial divestments, they perform even better during an economic downturn as valuations are lower and the potential returns are higher. Some of the all-time best returns ever made were investments during economic downturns and selling once the economy recovered.
Outcome is not correlated to current market conditions
Since early-stage valuations are often low they aren’t so much affected by market downturns, and so the final outcome is not related to current market conditions. The investments made in early-stage startups are not connected to daily fluctuations of the public stock market, so startup investors are not exposed to those market turns. Generally, the closer a company is to a potential exit, the closer their correlation to public valuations will be.
If a seed round valuation is around $10 million, a winning outcome could be at a valuation of $1 billion 10 years later. In September 2022 Morgan Creek released an analysis on venture fund performance across the last cycle, which reported superior returns from investments made during or right after the recession, particularly 2010, where a GP in the top 5% would have generated over 12x net TVPI.
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