The Startup Reset, Part I: The Music Stops

Startup valuations aren’t frothy, they’ve been red hot since the aftermath of Covid and the boil is about to build into vapour.

It’s only when the tide goes out that you discover who has been swimming naked.

Startups are in a bubble. You’d be kidding yourself if you didn’t agree. The opportunities that startups create simply cannot match the current onslaught of funding that is thrown at them. Not a week goes by as yet another billion-dollar unicorn is conceived from almost thin air.

One year-old food delivery startup Gorillas recently raised 1 billion dollars led by Delivery Hero, a rival Berlin-based startup which is struggling to spend the more than 8 billion dollars it has raised. The valuation of Sweden’s Klarna, Europe’s most valuable startup, rose by 35 billion dollars to 46 billion in the nine months to May. That’s 125 million per day. This is only Europe.

For the past ten years, more money has poured into global private markets than into public equity. This has helped inflate the world’s unicorn population by an eye-watering 25x. In the twelve weeks to December alone, more money was dumped into startups than during the entire .com bubble.

For the past ten years, more money has poured into private markets than into public equity.

That said, the frenzy may be even bigger at public tech firms where trading has been made increasingly effortless by commission-free trading apps such as Robinhood, birthing an avalanche of so-called YOLO investors and causing an unparallelled boom in retail tech, especially crypto fuelled meme stonks. Tesla is up 20-fold in two years, valuing the firm at a trillion dollars helped in part by meme and crypto. By revenue, Tesla is three times more expensive than the rest of the FANG+ put together.

An Excess of Excesses

Seven years ago, when I wrote that Nordic tech was about to boom, I couldn’t foresee this level of mania. Probably nobody could. Then, Nordic institutional Seed rounds were hovering at 200,000 dollars. Today, Seed rounds beyond 5 million are commonplace. If Nasdaq would today fall 75%, as it did after the .com bust, an equal slump in Seed rounds would still leave their valuations 5x higher than in 2015.

General partners, those who run the venture funds, are typically the last ones to call a bear. Admitting prices were too high would throttle investments from the limited partners who invest in their funds. Some first-time GPs and funds that still are fundraising may need to call in capital from the LPs for each individual investment. Funds further into their investment period are incentivised against calling a bear market.

Still, leading LPs are starting to look critically at 2022 and some GPs are sounding the alarm, those who already have a few vintages of high-performing funds behind them.

GPs seldom make their LP reports public. In an unconventionally candid manner, Lux Capital, the four-billion dollar venture fund based in New York, decided to release their third-quarter LP report to the public warning of an excess of excesses.

The Multiplying Impact of Technology

While revenues at tech startups are undeniably soaring, and the pace of innovation accelerating, much of the demand is created by the funding momentum itself.

Constant, but not continuous.

This is consistent with Carlota Perez’ techo-economic theory where technology multiplies its impact across economies through funding. The more funding, the more impact. The more impact, the more demand. The more demand, the more funding.

But this development isn’t linear, rather it is cyclical with an adjustment phase after every period of frenzy. With the funding volumes and valuations of today, we are arguably nearing a financial adjustment period where opportunities within technology can’t sustain the volume of funding.

So, what should tech founders do? When the music’s over, will you turn out the lights?

It depends.

Chaos vs. Structure

The internet, and technologies connected to it, is a complicated web of dependencies. A shift many degrees separated may have an outsized impact on a company’s business. And this relationship is made increasingly complicated as new venture investors birth new unicorns out of the blue and techno-libertarians push for more decentralisation (or is it recentralisation).

While it is difficult to predict when the bubble will burst — and what source will give the bubble its name (my favourite is the HODL bubble) — the idiosyncrasies within the web of connected technologies will make the by definition opaque private market even more complicated the bigger the bubble builds.

Some policymakers are starting to raise concerns over tech libertarianism and the ballooning valuations.

While authorities have been dovish towards private market regulation through laizzes-faire views and even supportive action — in hope that the new economy will create new jobs, which it of course has — some policymakers are starting to raise concerns over tech libertarianism and the ballooning valuations.

Eleven years of Nasdaq ahead of the burst of the .com bubble, superimposed on a similar eleven-year period until today.

“While large sophisticated investors have some ability to obtain disclosure, they sometimes almost inexplicably fail to do so,” SEC Commissioner Allison Herren Lee wrote in her October speech titled Going Dark: The Growth of Private Markets and the Impact on Investors and the Economy. “Remaining informed requires a position on the board, an avenue open only to a limited number of investors.”

The speech came just weeks before Sequoia Capital, probably the most storied venture fund of them all, said it will morph into an open-ended fund. At the same time, at three trillion dollars, the value of the cryptocurrency market is three times bigger than the U.S. subprime loan market which brought down the world’s financial markets in 2007.

While policymakers are starting only now to wake up to the gargantuan tech valuations and the increasingly opaque private market — to the displeasure of the YOLO’s on Twitter — founders who have raised oceans of capital at behemoth valuations may be left at sea when valuations get normalised.

The Delivery of Deliverance

How your startup will be affected by the downturn will in part depend on to which degree your business is dependent on the multiplying effect of the techno-economic theory. That is, how much of the demand for your product is borne from the funding momentum itself.

In the complicated web of dependencies, the products of some startups are dependent on other startups to do well.

Many startups can create growth by spending money they raised from venture funds on diverse factors that aid growth regardless of product. In the complicated web of dependencies, the products of some startups are dependent on other startups to do well. This relationship can be obscure and sometimes founders themselves may not have full transparency into it.

For example, Delivery Hero, having invested into rivals Deliveroo, Rappi and now Gorillas, has morphed into a de-facto food delivery investment vehicle. How does this translate into operations when the coffers at Delivery Hero start running dry? The excess money that is siphoned into the startup ecosystem is cascading the systemic risk, and this isn’t always immediately visible.

A Wolt courier riding a Voi scooter.

Probably the most recognizeable of this dependency is the food delivery and electric scooter startup relationship.

Everyone of us has seen a food delivery courier scooting through town on an electric scooter from one of the micromobility startups. When Covid came and emptied cities, couriers started stepping on scooters en masse.

Hence, if funding for food delivery startups gets disrupted, demand for electric scooter startups will be affected too.

In essence, what gets into question is whether your revenue really is recurring or propped up by venture funding through some obscure network effect.

Will the startup ecosystem grind to a halt tomorrow or next year will likely depend on an outside trigger, such as a collapse in speculative blue chips. What in turn would trigger that could be something that the techno-libertarians are fighting to end.

But not everyone will be left out at sea when the adjustment phase rolls in. It’s only when the tide goes out that you discover who has been swimming naked.

What gets into question is whether your revenue really is recurring or propped up by venture funding.

This is the first instalment in a series of three articles. The first about startup valuations being at unsustainable levels, the second about which startups may survive a subsequent downturn and the third about how the venture funding landscape may be affected post-crash.

Dr. Jonas Dromberg has researched venture capital funding flows at IE Business School in Madrid. He founded Revalence Ventures after having invested in startups with an exit ratio three times the industry average. He has lectured about venture capital and scaleups.

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Founder at Revalence Ventures. PhD in VC/PE funding with IE Business School. Former Bloomberg hack. Lecturer at leisure, also sailing.

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Dr Jonas Dromberg

Dr Jonas Dromberg

Founder at Revalence Ventures. PhD in VC/PE funding with IE Business School. Former Bloomberg hack. Lecturer at leisure, also sailing.

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