We’ve spent so long staring at record venture capital results around the world from Q2 that it’s nearly Q3.
We’ve seen record results from cities, countries and regions. There’s so much money sloshing around the venture capital and startup worlds that it’s hard to recall what they were like in leaner times. We’ve been in a bull market for tech upstarts for so long that it feels like the only possible state of affairs.
It’s not.
Digging back through our notes from the last few months from data sources, investors and founders, it’s clear that there are macroeconomic factors bolstering the startup economy. And there are changes to the economy that are providing additional lift. Secular tailwinds, if you will.
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But as the market giveth, it can also taketh away.
What might slow the startup boom? Similar to how certain macroeconomic conditions have provided a long-term boost, a reversal of those conditions could do the opposite. The secular trends powering startups — often on the demand side due to more rapid digitalization of global business — may be unconnected to the larger economy, a view underscored by software’s outsized performance during COVID-19 induced economic mess of mid-2020.
This morning, let’s talk about what’s fueling startups and their backers, and what could change. Because no bull market lasts forever.
Driving forces
Prominent among the macroeconomic conditions that have helped startups’ fundraising totals rise are globally low interest rates. Money is cheap around the world at the moment.
It doesn’t cost much to borrow money today, compared to historical norms. The result of that dynamic is that lending money doesn’t earn as much either. Bank yields are negative in real terms, and bond yields aren’t impressive.
Money always skates towards yield, so the low interest rate environment has led to lots of capital moving toward more lucrative investing options. This dynamic is partially responsible for the seemingly ever-rising stock market, for example. It’s also a partial explanation of why there is so much capital flowing into venture capital funds and other vehicles that push money into high-growth private companies. The money is looking for yield.
From a prior interview, Jeff Grabow, EY’s U.S. Venture Capital lead summarized the situation well this April:
Exuberance is running strong in the venture capital market. There are significant amounts of capital available driven by a prolonged low interest rate environment. There are strong investment themes being met with more startups in existence than ever before, and they will require more capital to thrive. Given this, we believe we’ll continue to see deal activity at an accelerated speed.
The other megatrend at play is a global move toward work digitization. This is the digital acceleration that we’ve heard so much about — where companies increasingly lean on digital solutions to make their work processes faster or more agile. While the concept and coinage of the term digital acceleration have been beaten to death over the years, conversations with CEOs and investors of all stripes and locations have convinced The Exchange team that, yes, this really is happening.
At this point, let us examine a dual-use example touching on each of two key points regarding why startups are seeing such huge demand.
During the early days of the COVID-19 lockdowns in the United States and Europe, there was concern in startupland that a snap recession could freeze private investment and perhaps curtail demand for startup-built products. Sentiment turned cold instantly, and for a now-forgotten period of weeks, there was something akin to a freeze amongst investors and startups.
It didn’t last. The stock markets recovered, lowering paper losses, but the sharp economic winds meant that money was kept cheap by central banks. And thus capital still needed yield. The result of the year’s drama was that by its end, venture capitalists had raised record sums for their investing work in 2020.
At the same time, those investors were rewarded as the larger global economy turned to software and other internet-delivered solutions. Going remote meant that employers needed new tooling and more of it than ever before. And a warm period for software sales warmed up further as digital transformation accelerated across the world.
Given the availability of cheap funds, continued yield hunger leading to record venture capital funds raised and a tailwind of demand for their core products, it’s not hard to see why startups are currently enjoying a record-breaking fundraising environment. Throw in Zoom-based investing, which allows more startups across geographies to enjoy access to funds previously tied to the office footprint of their investors, and things have been more than interesting.
What could go wrong?
First, let’s start with a bet on what’s unlikely to go wrong: In our opinion, the software demand boom is likely not stopping for some time. However, that still leaves plenty of space for tides to turn. Remember what we said about money seeking yield? Well, if money gets more expensive, it could stop flowing so eagerly into risky options like venture capital. It is not hard to envision a scenario in which this could happen: If financial authorities start having serious concerns about inflation, they will likely raise rates.
Rising rates will make other investments more attractive than they have been, which may lead to more assets being allocated to bonds and less into riskier investments like venture capital funds.
If VCs have fewer dollars available, the impact will be most likely felt on valuations. One could argue that current valuations are only accepted because of the market’s willing suspension of disbelief — or, if you are less pessimistic, thanks to a shared belief in the value of growth.
Several factors could shatter that trust. One is lower private valuations; another one is a long-running string of lackluster IPOs and underwhelming post-merger SPAC performances. All of these could lead the markets to question whether growth really does warrant such high multiples.
Such pessimism about valuation could also be fed by broader factors such as rapidly falling stock market prices and falling software prices, perhaps in the context of a macro downturn. We don’t know yet what could cause this, but one of the things this pandemic taught us is that black swans do exist. VC escaped relatively unscathed this time around, but that might not always be the case.
In particular, there are growing concerns about China. If the situation escalated into a cold or hot war involving China, Taiwan, Japan and the U.S. or India, it would have a major impact on supply chains, chip manufacture, and more generally on global trade.
How likely is a slowdown?
The conditions that are driving startup investment forward will change at some point. All we’re discussing today is the likelihood of them changing sooner rather than later.
But what we do think is possible to say with some certainty, or at least more than when a rebalancing of capital in the larger economy may occur, is that it will take a somewhat large shunt to knock the startup game off its current footing. Product demand coupled with funding interest is a killer combination for driving investment decisions — there’s capital chasing yield, and high-growth companies looking for capital. It’s a match made in heaven.
Moreover, many investors we’ve spoken to during this reporting cycle have been bullish about the quality of founders and startups they have the option of investing in. There’s not only market demand and capital, but what’s being built to answer the first with the help of the second is pretty good, at least in the view of the folks writing seven, eight and nine-figure checks to the startups in question.
Atlantico, a venture capital firm with a Latin American focus, noted in a report that “rising digital penetration” is only one factor spurring tech upstarts forward in the region. “Unsolved problems” was another. That implies that there is still much work for startups to do in many markets around the world, which means more startups founded, funded and perhaps exited. There’s good reason to think that the internal money cycle of venture is not running low on gas.
Perhaps what we’ll see — instead of a single, jarring shakeup of the startup economy — will be a slow rise in the price of money. That could lead to a multiyear cycle in which startups have to pay a bit more for their capital. And VCs would have less access to capital. That could slow things somewhat.
But from where we stand, the factors underpinning the startup fundraising boom appear solid and unlikely to unwind overnight. Still, no golden period shines forever, and even today’s luster will eventually tarnish.
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