The Startup Reset, Part III: Boiling Frog
Markets have a tendency to swing from one extreme to another, but this swing is the slowest in a century. Some startup founders and venture capitalists may not feel the boil despite a 1000-point plunge in S&P 500.
Not in a hundred years have market capitalisations declined for such a long period as today. As a result, startups— which as most private markets have stickier valuations than public equity — are in the midst of an unprecedentedly long period of uncertainty what comes to valuations. At the same time, many VCs are continuing to deploy funds as nothing had happened.
The Dow industrials index, tracked since 1896, has had straight weekly declines not seen since 1923. 1-9-2-3. But this depicts more the stubbornness of the momentum than the severity of the collapse. The S&P is still above pre-Covid levels despite a 1000-point correction from highs that coincided with the first instalment in this article series.
But tech investing isn’t a logically linear exercise, some funding stages are plunging while others are rising. U.S. Series B rounds in the first-half were up 11 percent from a year earlier as the Nasdaq plunged 21 percent in the same period. Given the decoupling there is a glaring dichotomy in early and late stage funding. Later funding rounds are frozen with overfunded startups seeing ten percent staff reductions across the board.
Sweden’s Klarna has taken an 85% valuation shave, which for Europe will probably become the poster child of this cycle’s exuberance. At best, the value of Klarna rose 125 million euros per day. At the same time, funding for earlier startups remain as hot as ever with venture fund portfolios adding hundreds if not thousands of jobs. These froglets are left boiling.
The lost vintages of 2020, 2021 and 2022
Here’s a line VCs don’t want to say aloud: Venture funds whose investment period coincided with the highs of exuberance won’t likely produce profits. 2020, 2021 and 2022 vintages are probably lost inflation adjusted. 2018 and 2019 may be difficult too with the plunging exit valuations. At worst, five vintages of VC fund gains will be wiped out. With seed round sizes still hovering stubbornly between five and 10 million euros it is near impossible to make gains amid a collapse in later stage funding. The toad has jumped the boil.
This imbalance in sequential funding puts founders in a precarious position. They are handed oceans of capital to scale to Series A, but when that with excessive funding bloated operation collides with product/market realities and the collapsed multiples of later stage funding, the founders are toast.
What’s more, the tech exuberance of 2020–2021 is gaining increased criticism about how the funds were deployed. One trillion dollars were deployed by the world’s venture funds in just two years, much of it in pre-IPO gambles, crypto exchanges and races for market dominance within food delivery and scooter startups. Many of these have already been wiped out.
Could the money have been used better?
For this topic I spoke to Carlota Perez who is considered by leading venture capitalists to be the mother of theories around capital and innovation. Luminaries from Marc Andreessen to Fred Wilson have sworn by her name.
Being the leading researcher of tech revolutions, and how funding leads to economic booms and busts, Carlota Perez voices disappointment over how her disciples have used the windfalls that came with the historically low interest rates.
Useless Innovations?
“VC is funding pretty useless innovations,” said Perez. “Quantitative easing and other liquidity poured into the financial markets have stopped the recoupling of finance and the real economy.”
While it may be fair to argue that NFT cartoons, loved by Andreessen, and TikTok, used to promote crypto scams, may not be very useful technologies, the ongoing collapse of the tech boom may lead to more meaningful investments, exactly as Perez has laid out in her theory. A16z, which may be in the eye of the wastefulness criticism, has quietly established a fund that focuses on more societally meaningful investments.
With interest rates now rising, quality may increase as hypercompetition between the funds begin abating. While the frog keeps boiling, finance and the economy may be on the verge of coupling again. Excess hype is getting evaporated and more meaningful technologies are being funded.
The low interest rate environment allowed “VCs fund escapist startups disconnected from the real problems of today,” said Perez. “Brilliant young innovative minds are being wasted!”
What happens to the “useless” technology that has been funded by overhyped investors remains uncertain. Without a sustainable market fit, it would probably be better to jump out of the boil. But with the continuing onslaught of billion-dollar funds, less meaningful startups will continue to get funded too.
While the boiling froglets may not produce gains for venture funds, the continued flow of funding will make sure that sometime, somewhere, a meaningful startup will also get funded.
With the ongoing tech slaughter, the shift in global geopolitics and the increase in interest rates, the biggest startup casualty may as well be “useless innovations.”
I’m excited to close this series with views by Carlota Perez who was the first scholar I cited in my doctoral dissertation. This ends the series.
Meanwhile, read Maxwell Strachan, the Nieman Fellow whose articles are always both entertaining and on-the-money.
This is the final instalment in a series of three articles about collapsing startup valuations. S&P has plunged more than 1000 points since the first article six months ago. The second article in April discussed the war in Ukraine and its eerie effect on tech valuations.
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.
