In 15 years as a venture capitalist, I’ve seen just about every market condition you can imagine. I started at Insight Venture Partners in 2000 at a time when the stock market was experiencing historic highs and tech companies were receiving massive private and public valuations. Capital markets were flush, startup burn rates were rampant, and the gold rush was on. Investors came out of every corner trying to get a piece of the pie.
We all know how that ended.
Fast forward to 2006, when I founded OpenView Venture Partners. Markets had rebounded from the 2001 disaster, and investment capital was beginning to flow back into VCs and tech startups. With a reasonably good idea and a solid team, most tech startups could secure growth capital. The environment wasn’t quite as crazy as 2000, but it was close.
Then, 2008 happened — and we all know how that ended.
Which brings us to today. While tech investment and VC activity climbed to its highest levels since 2000 last year, there’s a growing sentiment that we’ve reached a precipice. Private valuation euphoria seems to be dissipating. Tech IPOs are down (and the tech startups that have gone public are generally under-performing). Volatility in broader markets is creating uncertainty.
The combination of those factors is leading to some prognostication about the possibility of another tech bubble, but I don’t think we’re heading toward 2001 or 2008 again. Instead, what we’re experiencing now is more indicative of the market’s tolerance for higher-risk investments given those investments’ performance and other economic factors. For many, that trend is a harbinger for disaster. But in my book, it could be a good thing for the tech and VC industries as a whole.
Greed And Fear (And The Impact On Cash Burn)
Before I explain my point of view, I think it’s important to explore two forces that most often influence the ebbs and flows of tech investment participation, private valuations and startup cash burn: Greed and fear.
During the good times — when macroeconomic volatility and uncertainty is low — euphoria begets greed and you see much larger pockets of risk-on activities. In this environment, more investors have more money to deploy, and they’re more comfortable rolling the dice with higher risk investments. As a result, it’s far easier (and cheaper) for entrepreneurs to acquire and spend capital.
And why wouldn’t they? If capital is cheap and investing it in the business has the potential to yield exponential growth, why wouldn’t they “burn” it? This is no different from how most savvy individuals manage cash during periods of low-interest rates and strong economic growth. When capital is cheap and market opportunities appear high, you borrow for large purchases and invest cash in areas that have potential for a high return. (It’s important to clarify that I’m talking about deploying good capital on good financial opportunities, not raising and spending money just because you can.)
In the not so good times — think 2001 and 2008 — instability and volatility begets fear, which creates a very different ecosystem. Capital markets become more conservative (or freeze up entirely), which naturally raises the cost of acquiring that capital. VCs are choosier about the investments they make and terms become much less founder-friendly.
For startups with a sound economic model in a less competitive market, this might lead to a brief retraction in growth, but improved organizational efficiency. For startups with poor unit economics or a growth model that’s dependent on rapid cash burn to acquire users and tip gross margins in their favor, fear in the capital markets can be deadly.
So, Where Are We Now?
In the financial world, this ebb and flow phenomenon is often referred to as risk-on, risk-off investing, and it tends to create herd-like behavior.
In my mind, there’s little doubt that the VC and tech worlds are beginning to shift from greed to fear (or, risk-on to risk-off). Private valuations are beginning to normalize. Fewer tech startups are going public. And “tourist” VCs — hedge funds, public asset managers, and corporate venture capital groups that dabble in tech VC when market conditions are favorable — are starting to return home.
Additionally, there are several macroeconomic factors that are creating market uncertainty and, thus, less enthusiasm around riskier investments. Specifically:
- China’s growth has slowed, which is causing ripple effects across global capital markets and creating worries about volatility
- Interest rates remain low and there’s fear that won’t last
- Commodities are declining in price and the stock market isn’t rocketing upward
Collectively, these factors are creating risk-off preference in the market, which is lowering investors’ appetite for investments with unclear opportunities for a return. In the short-term, this will accelerate the demise of startups with poor economic models that previously relied on investor euphoria and the tech industry’s momentum to achieve sky-high valuations. And it will probably make it more difficult for some startups to acquire the runway necessary to test and prove the value of their ideas.
But this trend isn’t bad news for everyone.
For the startups that were fundamentally constructed to thrive in both lean and rich times, I don’t expect much to change. Focus and discipline have a way of insulating businesses against the ebbs and flows of the marketplace. If the capital markets are indeed moving toward a risk-off strategy, then these types of institutions will simply adapt.
For instance, a startup with sound unit economics might simply ramp down investment in product development or marketing and work harder to improve gross margins. Profitability, after all, has a funny way of limiting the need for outside capital.
The same is true in the venture capital industry.
For VCs that maintained a disciplined investment ethos and resisted the temptation to follow the herds toward trendy, high-risk opportunities, this new market uncertainty is less of a concern. In fact, in some ways, it’s beneficial.
In a risk-off environment, tourist investors move money out of VC and entrepreneurs are left with the fundamental investment groups that deeply understand their company’s needs, challenges and opportunities. In that environment, the capital that’s deployed is of higher quality and the value that’s created is significantly higher. Yes, fewer companies will go public in that setting, but the ones that do will be healthier and, thus, much more appealing to investors.
So, is the gold rush over? Not exactly. It’s just on hiatus. At the end of the day, markets tend to be cyclical. As valuations normalize and more disciplined investors pour money into more disciplined companies, it will yield successes that have a positive trickle down effect on the broader marketplace. When that happens, guess what’s right around the corner?
You got it: The risk-on herd. And when it comes back, capital will flow like water again, questionable economic models will return, burn rates will climb, and the valuation hand wringing will begin anew.