What Could Stop the Startup Boom?
The Current State of Venture Capital Funding
The second quarter's venture capital results have been under scrutiny for an extended period, and we are now approaching the third quarter.
Record-breaking funding figures have been observed across numerous cities, countries, and regions globally.
The sheer volume of capital flowing into the venture capital and startup ecosystems makes it difficult to remember periods of tighter financial conditions.
A prolonged bull market for tech startups has created a sense that this is the only conceivable scenario.
A Shift in Perspective
However, this is not necessarily the case.
A review of recent notes, data, and insights from investors and founders reveals that macroeconomic factors are currently supporting the startup economy.
Furthermore, evolving economic conditions are contributing to increased momentum, creating what can be described as secular tailwinds.
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Potential Factors for a Slowdown
Just as favorable market conditions can drive growth, adverse changes can lead to a slowdown.
A reversal of the macroeconomic conditions currently supporting startups could have the opposite effect.
The underlying trends driving startup success – frequently related to increased digitalization of business operations – may be independent of the broader economic climate.
The strong performance of the software sector during the economic disruption of mid-2020, caused by COVID-19, supports this perspective.
Today, we will examine the forces propelling startups and their investors, as well as the potential catalysts for change.
It’s important to remember that no bull market persists indefinitely.
Key Drivers of Startup Funding Growth
Globally low interest rates represent a significant macroeconomic factor contributing to the increase in startup fundraising. The cost of capital is currently quite low across international markets.
Compared to historical data, borrowing funds is presently inexpensive. Consequently, the returns on lending are also diminished. Real bank yields are negative, and bond yields remain unimpressive.
Capital naturally seeks opportunities for higher returns, and this low-interest-rate climate has spurred substantial investment into more profitable avenues. This trend partially explains the consistently rising stock market. It also accounts for the influx of capital into venture capital funds and other investment vehicles focused on high-growth, private companies, all in pursuit of yield.
Digital Transformation and Investment
Jeff Grabow, EY’s U.S. Venture Capital lead, aptly summarized the situation in an interview this April.
A major trend is the global shift towards work digitization. This digital acceleration – the increasing reliance on digital solutions to enhance speed and agility in work processes – has been widely discussed. Conversations with CEOs and investors globally have confirmed to The Exchange team that this trend is genuinely occurring.
Let's consider an example illustrating both key factors driving the high demand for startups.
Initial concerns during the COVID-19 lockdowns in the U.S. and Europe centered on a potential recession freezing private investment and reducing demand for startup products. Investor and startup sentiment cooled rapidly, resulting in a brief period of investment stagnation.
However, this proved temporary. Stock market recovery mitigated losses, while central banks maintained low interest rates in response to economic headwinds. Capital continued to seek yield. As a result, venture capitalists achieved record fundraising totals in 2020.
Simultaneously, the global economy increasingly adopted software and internet-based solutions. The shift to remote work created an unprecedented need for new tooling. This demand further accelerated as digital transformation gained momentum worldwide.
The combination of readily available, inexpensive funds, persistent yield expectations leading to record venture capital fundraising, and growing demand for core products explains the current record-breaking fundraising environment for startups. Furthermore, the adoption of remote investing via platforms like Zoom has broadened access to funding for startups beyond the traditional geographic limitations of investor offices, creating a particularly dynamic situation.
Potential Risks and Challenges
Initially, it's reasonable to anticipate continued strong demand for software for the foreseeable future. Nevertheless, conditions are subject to change, and potential downturns should be considered. As capital seeks returns, a rise in the cost of borrowing could curtail the flow of funds into ventures perceived as higher risk, such as those financed by venture capital.
A scenario where financial regulators become significantly concerned about inflation could trigger interest rate increases. This adjustment would make more conservative investment options, like bonds, comparatively appealing.
Reduced capital availability for VCs would likely exert downward pressure on company valuations. Current valuation levels may depend on a collective acceptance of growth potential, or a widespread belief in future value.
This confidence could be undermined by several events. Declining private valuations, coupled with a series of disappointing initial public offerings (IPOs) and underperforming special-purpose acquisition companies (SPACs), could cause the market to reassess growth-based multiples.
Broader economic factors, such as a significant stock market correction or a decline in software pricing during a macroeconomic slowdown, could further fuel valuation concerns. While the specific catalyst remains uncertain, recent events have demonstrated the possibility of unforeseen "black swan" events.
Geopolitical tensions, particularly those involving China, represent a growing area of concern. Escalation into a cold or even a hot war involving China, Taiwan, Japan, the U.S., or India would severely disrupt supply chains, semiconductor production, and international commerce.
Specific Areas of Vulnerability
- Interest Rate Hikes: Increased borrowing costs could divert investment from venture capital.
- Valuation Corrections: Disappointing market performance could challenge current growth-based valuations.
- Macroeconomic Downturn: A broader economic slowdown could negatively impact software pricing and investor sentiment.
- Geopolitical Instability: Conflict involving major global powers could disrupt supply chains and trade.
While venture capital proved resilient during the recent pandemic, future events may present different challenges. It’s crucial to acknowledge these potential risks and prepare for a range of possible outcomes.
The Potential for a Market Slowdown
The current factors propelling startup investment will inevitably shift. The central question we address is the probability of this transition occurring in the near future, rather than at some distant point.
However, a significant economic disruption would likely be required to substantially alter the present trajectory of the startup ecosystem. Strong product demand, combined with continued investor interest, forms a powerful catalyst for investment choices. Capital is actively seeking returns, and rapidly expanding companies are actively seeking funding – a mutually beneficial scenario.
Furthermore, numerous investors interviewed recently have expressed optimism regarding the caliber of both the founders and the startups they are considering for investment. Beyond market needs and available capital, the quality of the ventures being developed to address those needs is perceived as high by those allocating substantial, multi-million dollar investments.
Atlantico, a venture capital firm specializing in Latin America, highlighted in a recent report that increasing digital penetration is just one element driving growth in the region. The existence of “unsolved problems” was identified as another key factor. This suggests ongoing opportunities for startups globally, leading to continued formation, funding, and potential exits. The venture capital cycle doesn’t appear to be facing an imminent shortage of resources.
Instead of a sudden, dramatic upheaval, a gradual increase in the cost of capital may be more likely. This could initiate a prolonged period where startups face higher financing costs, and venture capitalists experience reduced access to funds. Such a scenario would likely moderate the current pace of growth.
Currently, the foundations supporting the startup fundraising surge appear robust and resistant to immediate collapse. Nevertheless, all periods of prosperity are finite, and even the most brilliant phases eventually diminish.
Factors Influencing Investment
Demand and Funding
A strong combination of product demand and available funding is a key driver of investment decisions. This creates a favorable environment for high-growth companies seeking capital.
Investor Sentiment
Many investors are optimistic about the quality of startups and founders they are evaluating. This positive outlook contributes to continued investment activity.
Regional Growth
Areas like Latin America are experiencing growth due to increased digital penetration and the presence of unsolved problems, creating opportunities for new ventures.
Potential Scenarios
Gradual Increase in Capital Costs
A slow rise in the price of money could lead to a multi-year cycle where startups pay more for funding, and VCs have less capital available.
Eventual Market Correction
While the current boom appears stable, no period of growth lasts indefinitely, and a future market correction is inevitable.