In the current economic landscape, many investors have become wary of venture capital investments. However, the ongoing downturn represents an advantageous opportunity to invest in the startup sector. This period of readjustment to a different economic cycle will not only show that this downturn is survivable but beneficial for the long-term health of the startup scene.
2022 brought about a series of unprecedented and challenging events for the global economy, the technology sector, and the venture capital landscape. But, despite the uncertainty, innovation remains a constant driving force across industries. The founding of new, promising startups continues, and the general sentiment in the industry is that valuations have become increasingly reasonable.
Despite a decline in activity level, as indicated by exits at the end of Q3 2022 in the venture capital sector, the levels still surpass the historical averages.
Source: PitchBook-NVCA Venture Monitor
At the same time, venture capital funds globally and in the US have a record amount of "dry powder" available for investment. Venture capital firms have honed their investment criteria and performed due diligence on prospective companies with a more critical lens, resulting in a higher likelihood of successful investments.
This presents a more rational investment landscape, where opportunities can be evaluated based on sound business fundamentals and long-term potential. As a result, VC firms, who take a more systematic approach to assessing potential investments, can invest in startups with a higher degree of confidence and maximize returns for their clients.
A year of two halves
2022 can definitely be characterized by two distinct periods with vastly different economic conditions. During the first half of the year, the global economy was recovering from the pandemic. People hadn’t been spending and were cashed up.
A frenzied buying spree started to arise, particularly in the crypto and NFT space, with people purchasing items at prices that did not accurately reflect their true worth. It was a clear indication of an overheated market, leading to predictions of an impending correction.
In the latter half of the year, multiple factors converged, resulting in the market bubble bursting. The conflict in Ukraine contributed to the energy crisis, leading to increased inflation. Inflationary concerns compounded the situation, causing central banks to take swift action to prevent inflation from spiralling out of control.
The fast-moving interest rate hikes implemented by central banks marked a significant shift in the investment scene. Investors were forced to adjust to the new reality of higher interest rates. Hence, the shift from artificially low interest rates, which had been the norm for a decade, to rapidly rising rates, was a stark reminder of the volatility and fragility of the global economy, serving as a cautionary tale of the importance of careful planning and strategic decision-making in the world of investment.
What happened then was that things came back to reality, bringing valuations back to a more reasonable level. Share prices dropped in value by 50% or more, with Tesla (a good example) falling by 65%. While this may appear to be a market disaster, it is, in fact, a normal part of market cycles and a necessary adjustment to re-establish proper valuations.
A good time to be investing
Investors exhibit a discerning mindset when engaging in venture investing during economic downturns. And as we become increasingly wary, it becomes more challenging for companies to secure funding. Consequently, it becomes crucial to differentiate between companies with genuine growth potential and those built on false pretences. Although it is a challenging period to raise funds, if it can be done effectively, the likelihood of strong performance is high.
On the other hand, current market conditions, characterised by rising interest rates and declining portfolios, will lead to a reduction in investment from casual investors and an increased willingness to consider lower valuations and venture capital involvement in business management.
Morgan Creek's recent analysis of venture fund performance sheds light on the potential for solid returns during economic downturns. The study, "History, Brain Development, and a Quality Reputation: Early-Stage Venture Capital Performance When Emerging from an Economic Downturn" (September 2022), assessed the performance of venture funds over the previous economic cycle and found that the best performances were in those years closest to the downturn. This was indicated by their Total Value to Paid-In (TVPI) and Distributed Value to Paid-In (DVPI) multiples.
Source: Morgan Creek “History, Brain Development, and a Quality Reputation: Early-Stage Venture Capital Performance When Emerging from an Economic Downturn” (September 2022).
The study's findings are particularly noteworthy for early-stage investors. The analysis observed that early-stage funds outperformed later-stage and multi-stage managers in 2010, 2011, and 2012, with net IRRs of 32.3%, 23.6%, and 19.4%, respectively.
As many of us remember, the dot-com bubble's collapse exposed the fragility of companies built on unsustainable business models and overhyped potential. The dot-com bubble was a period of excessive speculation and growth in the technology industry, particularly in the internet sector, around the late 1990s to early 2000s.
During this time, the stock prices of many Internet-based companies, also known as dot coms, rose dramatically as investors poured money into these firms without fully understanding their business models or future profitability.
The bubble eventually burst as investors realised that many of these companies were overvalued and unsustainable, leading to a sharp drop in stock prices and widespread losses for investors. Hence, it reinforced the importance of investing in companies with sound fundamentals and long-term growth potential.
In the aftermath of the dot-com bubble, companies like Amazon and Google, which had solid business plans and were well-positioned for growth, continued to thrive and became dominant players in the tech industry. This highlights the opportunities that can arise during economic downturns for investors to pick up undervalued assets and capitalise on the market's recovery.
Seed Space’s investment criteria in times of uncertainty
At Seed Space, our strategy remains focused on early-stage FinTech companies with strong an underlying business models, and we use our expertise and know-how to create value. Our investment criteria have not changed, but our deal terms have become increasingly stringent. We thoroughly analyse the companies through our review process, asking companies to provide worst-case scenarios and to consider a range of things that could negatively impact the business. Targeting founders who are open to getting advice and support, not just money, is also a continuous theme.
With over 200 years of combined experience in our Investment Committee, we have leveraged our skills and knowledge to make smarter investment decisions.
And though some investments have struggled, we are immensely proud that we have been able to work with founders to successfully restructure the majority of those companies. This track record and approach continue to define our story as a VC firm.