If you’re launching a startup, it’s best not to overthink macroeconomics. It’s outside of your control and impossible to predict. Better to focus your energy on what you can control.
Still, it’s prudent to have some awareness of economic cycles and what they mean for your business. While it’s impossible to predict what will unfold with the global economy ten weeks or three years from now, it is possible to read a few tea leaves and sniff around at where we are, broadly speaking, within an economic cycle. That small bit of awareness might be the difference between weathering a rough patch in the economy and finding yourself in a dark, narrow tunnel staring at a pair of fast-approaching lights without any room to maneuver.
Two stories have dominated the financial news over the past month. First, the Greek government briefly defaulted on its sovereign debt in early July, only to receive a $96 billion bailout on Monday from the European Union to avoid a total meltdown. Second, around the same time things got messy in Greece, the Chinese stock market took a brief but harrowing walk off a cliff, with the Shanghai SSE composite falling over 32% in less than a month.
The two news stories, unrelated in almost every measurable way, moved in tandem in a strange intercontinental market-dance. The peak hysteria in panicked headlines in Greece coincided with the biggest selloffs in China, and the news of a bailout in Greece arrived just as the Chinese stock market rebounded (albeit briefly).
In much the same way that Greek debt and Chinese stocks don’t have much to do with each other, we could argue that these global macroeconomic events do not have obvious connections to startups here. But there is an important lesson for startups embedded in these seemingly unrelated headlines. Namely, that a startup’s ability to access capital markets may be determined by exogenous events totally outside of its control. In good times, companies that might not merit funding often get it anyway. In tough times, companies that do deserve funding often cannot.
When it comes to high-risk investment vehicles, it doesn’t get much higher risk than Greek sovereign debt. About half the time that Greece has been a sovereign nation, its debt has been in default. Presently, the market considers default a near certainty.
Still, time and again, the international financial community has extended Greek credit lines, knowing that Greece wouldn’t likely pay them back, to avoid a global contagion after the great recession.
A startup’s ability to access capital markets may be determined by exogenous events totally outside of its control.
After five years of pretending and extending, as of last week, the situation appeared untenable for Greece and its lenders. Greek voters rejected further austerity measures in a referendum, and it seemed that Greece would face reality, default on its debt, and leave the Euro. Then, as the Greek economy unraveled, Greece agreed to further austerity and signed an agreement for a $96 billion loan to cover its debts.
It’s a stop-gap agreement that requires more of the same failed policies that have led to 25% unemployment and 50% youth employment over the past five years. Few observers expect the bailout to succeed.
As StockTwits founder Howard Lindzon pointed out, the Greek stock market is smaller than Bed, Bath, & Beyond. It shouldn’t move the needle here.
China, however, is a much larger economy. It’s about 40 times the size of Greece. And right around the time the Greek economy foundered, the Chinese stock market, long considered by many to be in the midst of a massive bubble, plunged more than 30% in a few weeks. Unlike in the US, where the majority of money invested in the market is run by large funds, in China, four-fifths of the money in the market belongs to individuals.
Turns out, many of those investors were investing in the market based on margin, which is essentially a risky form of credit. Now those who lent them the money are asking for their money back, in what’s referred to as a “margin call.”
As of last Wednesday, according to Bloomberg, “At least 1,331 companies have halted trading on China’s mainland exchanges, freezing $2.6 trillion of shares, or about 40 percent of the country’s market value.” Basically, things got so bad, China’s government shut down nearly half of the stock market.
There is no logical reason why Greek debt restructuring should have any impact on the stock markets of East Asia, or startups in the United States. But economic cycles are driven by complex relationships with expanding and contracting credit flows, and the exact entanglements are difficult to discern except in retrospect. Hedge fund manager Ray Dalio explained this in his fantastic video called How the Economic Machine Works, “When credit is easily available, there is an expansion. When it isn’t easily available, there is a recession.”
Much like Greek debt and Chinese stocks, startups are high-risk investments. Startups as an asset class aren’t as risky as Greek debt, but they’re somewhere on the spectrum. As an economic cycle turns, the contraction of credit tends to impact the highest risk investments first, such as Greek debt and Chinese stocks, followed by the next-riskiest investments, until, as the wave of pessimism rolls through the economy, all asset prices face pressure. Startups, as a high-risk investment class, are particularly susceptible to these credit-market fluctuations.
Most analysts look at bubbles in terms of valuations, but bubbles don’t burst because valuations get too high, bubbles burst when investors become more concerned about the return of their capital than return on their capital. And when that happens for startups, follow-on rounds for marginal companies fail, convertible notes don’t get extended, and companies go belly up. In that, the financial picture of an insolvent Greece isn’t too far removed from a not-yet-solvent startup.
Few would dispute that are witnessing near-perfect conditions in capital-market access for startups, whatever the stage.
While many look to valuations to know whether the startup market has overheated, the reality is that the forces that drive credit to startups extend far beyond the startup community.
If you’ve built or worked for a startup lately, and you’ve been able to show traction and competence, you’ve probably had access to capital.
There are many investors, professional and amateur, investing in startups now, because it’s difficult to find yield elsewhere. It’s driving talent, attention, and resources to startups, and providing opportunities to startups and growth to adjacent side businesses that service the community. And as more investors do this, companies can raise at higher valuations compared to prior years.
While many look to valuations to know whether the startup market has overheated, the reality is that the forces that drive credit to startups extend far beyond the startup community.
In 2007, the market started to turn when a collection of subprime borrowers defaulted on mortgages they never should have been given in the first place. This flooded the market with foreclosures, putting downward pressure on house prices, leading to more foreclosures, which then put strain on the capital reserves for banks. Many banks failed. It soon became difficult for even the most credit-worthy borrowers to get access to capital.
In 2008, many startups that would have had access to capital only a few months prior saw the spigots completely shut off. By January 2009, Apple stock had fallen nearly 70% from its peak in 2007. Not because the company didn’t have a bright future, but because investor focus had switched from return on capital to the return of capital.
While it is unlikely that recent events in Greece and China will cause a short-term disruption in startups funding, founders need to be cognizant of how quickly markets can change.
The near-perfect capital-market access for startups will not last forever, and that we are nearer to the end of the current credit cycle than the beginning.