Based on recent venture funding figures, now might not seem like the best time to invest in startups. Figures show that VC funding levels are down across the board, and particularly at later stage, which saw a drop of 40% quarter-over-quarter in Q2 and 63% year-over-year. Various media outlets are also predicting leaner times for the sector, with The Financial Times recently declaring that the ‘party is over’ for VCs.
Investor sentiment is a powerful thing and with the current economic turmoil, it’s only natural that many venture investors and LPs are considering their options. But, before battening down the hatches, it’s important to remember that VC is distinct from other areas of asset management in being less closely aligned to economic trends. And in the VC world, top line funding figures and turbulent markets are often a distraction from the chance to get in on some of the most promising deals – at just the right moment.
Here are five reasons why now could be the best time to invest in early-stage businesses.
1. Valuations are back to reasonable levels
Startup valuations reached crazy heights in the last few years, in many cases sparked by pandemic driven business models that failed the sustainability test. Last year, it wasn’t unusual to see 30x multiples for some software companies, which made the work of VCs increasingly expensive – and risky to boot.
However, there has been a shift this year, with many valuations falling to a much more reasonable 8-10x in recent months. And while lower valuations present challenges for founders and existing investors who are seeing their equity impacted, they also mean lower entry points for VCs, particularly at the early stage, while giving companies more room to grow as the economy gradually recovers.
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2. Digital transformation and big problems won’t disappear
The economic situation may look dire, but it doesn’t impact the macro trends that are driving the best business ideas. Digital transformation is still progressing rapidly, with many legacy businesses being transformed by the capabilities of technology. In most cases, this is the only way to achieve the efficiency gains needed to meet societal and client demands, and it won’t grind to a halt just because market sentiment has shifted.
Similarly, the world still faces huge problems and challenges, and technology remains the best solution to address these. Whether it’s building more sustainable energy networks, providing cutting-edge healthcare, or delivering better, more equitable financial services, clever entrepreneurs and startups have no shortage of challenges to solve, in their quest to build a better world – and world-leading companies.
3. History is on our side
History shows us that economic downturns are periods of rich creativity and innovation as entrepreneurs are forced to focus on the real problems facing the world, and the most urgent needs in a capital efficient manner. Research shows that half of the Fortune 500 were created in a downturn, including GE, established by Thomas Edison in 1876 in the middle of a world recession, Microsoft, founded in 1975 whilst the US was submerged in stagflation, and LinkedIn in 2002, on the back of the dot-com bubble. There is no reason why this downturn should be any different.
4. The chance to invest in more resilient companies – and founders
A downturn could also work to investors advantage by instilling greater resilience in founding teams and forcing them to become more capital efficient. Capital efficiency is already going up due to lower valuations (improving dilution aspects) and the fact that entrepreneurs appreciate the value of cash much more in downturns. We are already seeing a renewed focus on the fundamentals of healthy, sustainable business growth, as opposed to the ‘growth at all costs’ mentality that has dominated in recent years.
The current crop of startups may also face less competition, both for market share and talent, as more established businesses make cuts and layoffs. Combined with the potential for better deals when negotiating office space, subscriptions, and other overheads, reducing these costs could all help to propel businesses on.
Above all, adversity can be a huge motivator and, for true entrepreneurs, the ability to take and endure risk is what differentiates them from the rest of the population. For the most committed recession-proof individuals, a bit of economic turbulence is unlikely to divert them from their mission.
5. Forging stronger VC partnerships
It isn’t just the most committed entrepreneurs who rise to the top during challenging times; the same can be said for VCs. The best and most experienced VCs have weathered previous downturns and are therefore skilled at spotting and nurturing recession-proof entrepreneurs and giving them hands-on support, to ensure that they continue to grow sustainably, take the opportunities presented to them, while building a clear path to profit.
Building the legendary ‘class of 2022’
Despite the short-term pain, downturns don’t last forever and are historically followed by a longer period of growth than the period of recession. And despite the economic headwinds, there are always opportunities for those ready to grasp them, with the right focus, talent, and execution.
For venture investors, the ingredients are all there to back, support and create great companies – lower valuations, a more capital efficient environment, highly resilient and determined entrepreneurs, and the potential for stronger relationships with founders and their teams. Those who take advantage now will have an outsized impact when the economy roars back to life.
To succeed, VCs will need to use all their experience, networks, and gut feel, to identify the entrepreneurs who have what it takes to defy the negative outlook – and who will go on to become industry leaders, and one day be known as the legendary ‘class of 2022’.