Why the Market Slowdown is a Good Thing for Investors AND Startups
The VC market exploded over the last several years. Look at any metric—capital raised, number of deals, average deal size, etc.—and you will see a hockey stick trajectory (up and to the right).
2022 has been a different story. As outlined in our latest article, the volume and pace of deals have slowed considerably. VCs are being more patient and more selective in their investment decisions while they evaluate market conditions.
This, unsurprisingly, has founders worried about their ability to raise capital and at what valuation.
Although these concerns are valid, the slowdown is exactly what both parties—investors AND startups—need to thrive together in the long run.
How can a slowdown, particularly for startups raising capital, be seen as a positive development?
In a word, TIME.
Once Upon a Time There Was No Time
There are a lot of explanations for why private capital investment exploded in recent years—the emergence of mega-funds, increased participation from “tourist investors,” loose monetary policy, and popularity in pop culture (e.g., WeWork documentary), among other factors.
Whatever the reason, the red hot market had a profound impact on the fundraising process for investors and startups.
Bearish on Bull Markets
Bull markets are typically portrayed in a positive light. Business is booming, money is flowing, employment opportunities are plentiful - what could be bad about that?
Trouble emerges, though, when things get overheated. At a certain point, decisions become less grounded in reality and, instead, are based on an excessive optimism that asset prices will continue to appreciate (that’s what they had been doing up to this point, so why would they stop now?). Howard Marks characterizes bull markets as “exuberance, confidence, credulousness, and a willingness to pay high prices for assets.” The rise can be intoxicating and further increases only validate your prior beliefs that the market is strong.
Even if you believe we are in a bubble, it is extremely hard (and costly) to sit on the sideline. Trying to time market swings is nearly impossible no matter how experienced or skilled you are. Bull markets can continue to grow and grow for years, which is exactly what happened from 2009 to 2020. Betting on the market to cool off in 2013 (the average length of a bull market is 4 years) would have left you hurting. Thus, investors feel obliged to continue dancing until the music turns off, whenever that may be.
Impact on the Fundraising Process
VC firms were pressured to deploy capital as quickly as possible while startups were encouraged to raise as much money as possible to keep pace.
As a result, the fundraising and due diligence process was often condensed into an unreasonably short period of time. Deena Shakir, partner at Lux Capital, describes how quickly things were moving, saying, “You’d see a pitch and the founder would have 10 term sheets within 24 hours without the type of diligence that you would want to do. That’s not really happening anymore [in 2022].”
Investors either had to jump on board or miss the boat entirely. Eric Vishria, partner at Benchmark Capital, attributes the mad rush to a fear of missing out, saying, “If there was one word to describe it, it was FOMO.” Investors had to concede to inflated valuations, hurriedly evaluate investment opportunities, and forego a proper due diligence process to ensure a spot on the cap table.
On the other side, startups seeking to raise capital ostensibly benefited from an overheated market. They quickly raise more money at a high valuation. Again, what could be bad about that?
Two (false) assumptions must be made to believe there are no side effects to an overheated market:
Capital from VCs is purely a commodity
Capital does not have a diminishing return (i.e., the more capital, the better)
Beyond Capital
VCs and angels provide value to startups above and beyond capital—access to their network, strategic counsel and guidance, and operational assistance, among other services.
Choosing the right investor can accelerate the growth of your business and increase the chances of long-term success. Choosing the wrong investor, however, can at best be a nuisance and at worst initiate a downward spiral for your startup.
By shortcutting the fundraising and due diligence process, startups miss out on the opportunity to get to know prospective investors and determine who is the best fit for their business. Remember, you are forming a partnership with this person or firm for the next 5+ years. Making a hasty decision can cost you for years to come.
Diminishing Returns
Startups only have so much bandwidth to put capital to work effectively. It is tempting to believe all your problems can be solved with more capital, but that is rarely the case. Yes, “blitzscaling,” which involves capturing and dominating a market before others can enter by growing at hyper-speed, has been successfully employed by startups such as LinkedIn to wonderous effects. But the reality is that this method only works for a select set of companies at a particular point in time. Most companies are not ready or not well positioned to deploy this strategy.
The influx of huge amounts of cash before reaching product-market fit transforms the core asset of a business from the product to the capital itself. Capital becomes the driver of growth rather than a fuel source. Fundraising becomes the milestone rather than a vehicle for achieving milestones that increase a startup’s intrinsic business value.
Flush with capital and under pressure to live up to inflated valuations, startups burn money quickly to fuel short-term growth (even if it was inefficient or at the expense of long-term value creation). This approach can work well when things are good and more money is around the corner. But, as we’ve seen in 2022, things can sour fast. Once capital runs dry, startups that are overly dependent on more cash to progress are quickly exposed.
Unable to Resist
It is hard to blame startups that raised too much capital too quickly. If investors are asking you to take their money and are willing to pay a high valuation, why wouldn’t you? Further, when competitors are raising exorbitant amounts of cash, startups feel compelled to do the same just to keep up.
Founders were akin to sprinters tripping over hurdles because they were too focused on running as quickly as possible.
Time is on Your Side
This brings us to 2022. Capital is allocated more selectively but time is more abundant. Investors and startups have an opportunity to take a deep breath and re-evaluate their priorities and agendas.
MORE TIME allows investors to:
- Review more deals before making investments
- Conduct due diligence more thoroughly
- Build better relationships with prospective founders
- Avoid making hasty decisions based on hype
MORE TIME allows startups to:
- Receive and review competing investment offers
- Conduct due diligence on investors
- Build better relationships with prospective investors
- Avoid the temptation of luring investors by overhyping opportunity
- Carefully think through how much capital is needed and its purpose
Take Your Time
The fundraising process can result in much more than a check at the end of the day. Use this time to understand your market and competitors, craft a compelling story about your business, develop a well-thought-out plan on how you will use funds to scale, and, eventually, find the right investor for your particular business.
A thoughtful fundraising strategy will improve your chances of a successful raise with the right partner.
If you haven’t already, read our article on why startups need at least 8 weeks to prepare for fundraising.
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