Economic cycles, comprising expansions and recessions, directly impact venture funds raising and investing in startups.
During an expansion, startups are often valued at very optimistic prices. Investors extrapolate the startup’s growth rate or future potential, assuming it will continue forever. As we have seen in 2021, startups had crazy valuations, up to 1,000 times their revenue in some cases. VCs were fighting to invest in “hot” startups. Both VCs and entrepreneurs thought that it would continue like that forever. The zero-interest-rate loans exacerbated the situation; many borrowed to invest in high-risk assets.
When the economy starts to cool down, and interest rates get high due to government intervention, spending cools down, impacting the startups' growth rates. Investors’ euphoria starts to fade away, feel unexcited about startups' valuations, and eventually, fear kicks in. At this time, many high-flying startups, such as Stripe, Brex, and Snyk, lost nearly 50% of their 2021 valuations with the same economic conditions of an economic downturn.
Most Investors extrapolate and think that both sides of the cycle will continue indefinitely, which makes their fund returns subpar
As I mentioned, most investors extrapolate and think that both sides of the cycle will continue indefinitely or for overly long periods. As a result, they become over-optimistic about their investment during the economic expansion, leading to bad investments based on FOMO, lousy due diligence, and factors that don’t matter when building a healthy business. You need to be cautious and alert when to exit when everyone is greedy and feels that the good times will continue for a long time. At these times, you must be defensive; It might be time to take some of your returns earlier than anticipated; If you are getting into a new investment, you must maintain your discipline to perform the proper due diligence and assess the opportunities of getting the highest possible returns given the stage of your fund.
The opposite is true; it is time to be aggressive when everyone else is fearful and feels the sky is falling. This is when good deals and great entrepreneurs show up to build the next multi-billion dollar business. It requires patience to find good deals and agility to close on these deals and invest in the best entrepreneurs and startups without hesitation.
With the correct ratio of risk and reward, you may need to be correct about your investments only 50% of the time.
Timing your investments in the cycle takes work. Remember that it is almost impossible to avoid investing at the peak of economic expansion or the absolute bottom of the economic cycle. With the correct ratio of risk and reward, you may need to be correct about your investments only 50% of the time.
Being conscious of where you are in the economic cycle will help manage risks and improve investment outcomes
By asking the right questions, you can make more informed, objective investment decisions that take into account the economic cycle's current stage and the inevitability of changes in the current cycle. There is no guarantee of success.
As I mentioned, accurately predicting economic cycles is impossible, and startup investing is inherently risky. However, being conscious of where you are in the economic cycle will help manage risks and improve investment outcomes. Therefore, you must be laser-focused on asking the right questions to frame your mindset and investment position objectively. Here are some crucial questions that VCs can consider:
What stage of the economic cycle are we in? Understanding whether the economy is in an expansion, peak, contraction, or trough phase is critical to understanding the macroeconomic context of your investment. It is not easy to know if we reached the peak, but the key is understanding the general psychology of other VCs and being conscious of their current state.
How does the startup's industry sector perform during this phase of the economic cycle? Different sectors respond differently to various stages of economic cycles. Some are cyclically sensitive, while others are more defensive. Is your next startup investment about to be impacted positively or negatively by the inevitable economic changes?
What is the risk/return tradeoff at this stage of the cycle? When the economy is booming, valuations may be high, potentially reducing future returns and increasing risk. There might also be more risk when the economy contracts, but the potential for high returns could be more significant. It is certainly counterintuitive and hard to achieve, especially for first-time fund managers and LPs. During economic downturns, many LPs look for “safe” areas to invest their money and shy away from high-risk-high-return investments, making it exceptionally difficult for fund managers to raise money. It also makes investments exceptionally difficult since it is hard to differentiate between good and bad startups in their early stages.
How likely is the startup to survive a downturn if one occurs? The startup's financial health, burn rate, runway, and ability to raise additional funding if needed are all relevant factors. This comes to building an anti-fragile company with exceptional capital efficiency. When I invest in companies, I always bring the founders to the reality of the current economic cycle. Entrepreneurs are not immune from being overly optimistic about their ability to get more funds and their startup operations. Is this startup ready for the downturn? And also the economic recovery?
How does this investment fit within the portfolio? Considering portfolio diversification is crucial in managing risk. It's essential to understand how a potential investment correlates with other investments in the portfolio. Not all investments will be 100% optimized. But considering the impact of your past investments on your portfolio returns should guide you if you need to be more aggressive or cautious during the capital deployment period.
What is the startup's competitive advantage, and how will it be affected by economic changes? It's essential to understand whether the startup's competitive advantage is durable and can withstand different economic conditions; or does it exist because of unsustainable economic hype.
How experienced is the team in handling economic shifts? A seasoned team that has weathered economic ups and downs may be better equipped to navigate uncertain conditions. If they don’t have enough experience yet, I recommend focusing on their awareness of these cycles rather than the team having any experience going through previous economic cycles.
Is the startup's business model flexible and adaptable? Economic changes often require businesses to pivot. A startup with flexibility and adaptability is more likely to weather economic shifts. Look at how they validated their idea. I usually ask how they handle customer and market signals to assess their ability to pivot and adapt.
What is the startup's valuation, and does it reflect current market conditions? It's crucial to understand whether the startup's valuation makes sense given the current stage of the economic cycle. Unfortunately, many entrepreneurs and VCs are ignorant of the economic cycles and overvalue their startups and hurting their startup’s long-term ROI.
Economic cycles impact startups and VCs' appetite to invest in them most. Understanding the economic cycle and where you stand is your first step to making sound decisions. Discipline is what truly determines your success in your investments.
My next article will discuss credit cycles and their impact on venture funding. Stay tuned!