Right now, the VC market feels as effervescent as a bottle of Moët. Here’s what to do if and when the fizz goes flat.
To hear it from reporters covering the venture capital scene, startups are swimming in VC loot a la Scrooge McDuck. Numbers from Crunchbase claim that global VC money in the first quarter of 2018 beat the previous highs from 2017, bringing the market to its highest peak since the dot-com crash. Impressive — but those numbers don’t tell the whole story.
The Q1 report looked great, but the Q2 report is even dreamier, as deal and dollar volume continued to grow after Q1. That might not be as great as it sounds, though. Sure, $100 billion funds, $14 billion funding rounds and billion-dollar scooter companies are cool, but things are starting to feel a little bubbly.
Shortly before the dot-com bubble popped, US VC peaked in Q2 of 2000. During those months, investors ponied up about $30 billion. Last quarter’s $23 billion inched the market one step closer to previous highs that proved unsustainable.
For the moment, getting VC money is as easy as ordering a poke bowl on Uber Eats. But these good times never seem to last. The exit market is murky, and undeployed funds cloud the future of VC investment. The numbers might seem promising on the surface, but the factors fueling this heavy investment could soon come back to bite us all.
Factors driving VC growth
Investors put their money into vehicles they expect will get them a fair risk-adjusted return. A simple concept, but it’s not as straightforward as it sounds.
Heavy tech investment outside of San Francisco is currently at an all-time high. Thanks to modern technology, tech startups can operate anywhere. Intuitive tools allow founders who might not have a technical background to build technologically competent companies. This commoditization of tech development has equalized the market, opening up tech investment opportunities beyond Silicon Valley.
Investments outside America have also affected the VC market. According to research from KPMG, a larger proportion of VC dollars than ever before went to companies outside the U.S. last quarter. Mary Meeker’s 2018 Internet Trends Report states that 49 percent of the world is online, which opens up both resources and market opportunities to international contenders.
Companies are receiving more money in more places, and they are also growing more rapidly than ever before. Thanks to exponential tech trends, startups can reach unicorn status within a matter of months. And don’t even get me started on the subject of blockchain valuation trajectories — it’s insane.
On a grander scale, macroeconomic conditions have provided the perfect foundation for an accelerated investment landscape. Investors have record amounts of capital to invest — an estimated $1.8 trillion per McKinsey — and they are eager to put that “dry powder” to use. If deal activity begins to slip and investors lack a place to put that powder, though, things could get ugly. Global interest rates remain low, but CBNC reports that some are nervous about a flattening yield curve, which historically signals recessions.
Those macroeconomic conditions are the most dangerous piece of the puzzle. A recession would not stop global internet adoption or regional investment trends, but it would reduce the flow of capital in the venture asset class. Interest rates dip during recessions to drive spending, but they are already quite low. If the bubble bursts and there is nowhere left to turn for relief, the market could enter a recession that rivals the dot-com crash.
Despite looming threats, the startup world will generally be fine. Entrepreneurs have been through this before and proven themselves to be a resilient bunch. But if and when the other shoe drops, some companies will inevitably fail to come out the other side. Successful founders should follow these tips to survive a drought in investment dollars:
1. Get profitable quickly.
Say goodbye to vanity metrics. In a recession, VCs don’t care about monthly active users or growth rates; markets look at revenue with less favor. The new magic number becomes earnings before interest, taxes, depreciation, and amortization (EBITDA), which boils down to net operating profits.
Profitable reality can be tough, so figure out how to run and sustain a profitable business model before market shifts make it even tougher. If a study by the National Bureau of Economic Research is accurate, about 50 percent of all unicorns are significantly overvalued. The study examined 135 startups with valuations of more than $1 billion, and the researchers found that 65 of those companies should actually have been valued at less than $1 billion.
Being overvalued is no way to survive a recession. Instead of relying on overinflated valuations, find your lever to translate potential into profit as quickly as possible.
2. Grow with in-house cash.
When venture dollars dry up, founders depend on their own reserves (and cash flow) to fuel growth. That growth will be slower, so you will have to get creative with your growth strategies to make it work. Use free cash flow or take advantage of debt financing, which will have low rates in the event of a macroeconomic downturn.
Don’t believe the hype that VC capital is the only path to success. Plenty of companies ride the wave of VC dollars, but plenty of others do just fine on their own. Jon Oringer, for instance, started photo service Shutterstock by uploading 30,000 images from his own personal library. From those humble beginnings, Shutterstock has flourished into a billion-dollar company.
3. Find opportunities in the root of the recession.
What caused this theoretical recession of the future? Was it student loan debt, credit card debt, an international trade war or an alien attack? (Yes, I’ve been watching too many episodes of “Ancient Aliens.”) Unpack the systemic issues that caused the big problems, then dive into the causes to create a recession-proof company in the cracks.
Not every business suffers when the market goes down. Walmart, for instance, thrived during the crash of the late 2000s because consumers were hungry for discounts. Most small businesses suffered, but Winmark franchises (sellers of resale goods) flourished. Find a niche immune to the disorder and figure out a way to capitalize on it. Some of the biggest companies in U.S. history were born during recessions, including the likes of IBM, General Electric and FedEx.
4. Take advantage of big company slowdowns.
Most major corporations (aside from Walmart) are the first to slow down when a recession strikes. Take advantage of their reduced spending on research, product quality and innovation to disrupt their arenas while they’re hibernating.
Research published in Harvard Business Review found that 9 percent of companies did better after a slowdown than before it. That number isn’t super high, but it also isn’t infinitesimally low; it shows that founders with an eye for opportunity can thrive no matter what the circumstances.
Recessions aren’t exactly fun, but they offer entrepreneurs unique opportunities to innovate and expand. Whether the hammer falls this year, next year or in 2025, today’s founders must be resilient if they want to remain. When the economy dips, VC dollars won’t be waiting in the wings to save companies caught in the crossfire. Accept the inevitable and prepare to thrive while other companies scramble to survive.