This article was first published on John Spindler’s LinkedIn platform.

This blog was kindly provided by John Spindler, the CEO of Capital Enterprise. John is also a member of the BIG South London Programmes board. This first instalment of a two-part series explores the present downsides of innovation investment. The second part, yet to be published, will detail the positives and explore what the future may look like. 

Will the bursting of the tech valuation bubble, high inflation, increasing interest rates and the resulting cost of living crisis impact the prospects of tech startups and their investors? The obvious answer is yes but the interesting nuance is going to be where and how in particular the impact on the Innovation Economy.

Firstly, since I have just finished re-reading Bill Janeway’s excellent book Doing Capitalism in the Innovation Economy, I want to give recognition that the Tech bubble whilst it lasted, has over the past 12 years resulted in more capital than ever before invested in Tech startups. Admittedly a lot of this cash was invested by millennials in VCs to alleviate the plight of millennials. You do not need to be Sherlock to know what millennial investors invest in. If you work long and irregular hours in the knowledge economy in congested cities, renting smaller and smaller over-priced flats that give little space to cook or entertain, carless and dependent on public transport, sacrificing physical resources for the abundance of online choices and online personas that results in spending an enormous amount of time trying to navigate and build, are unable to save at the same pace of asset inflation and subsequently susceptible to any quick rich schemes or offers to offset paying for things to the never-never and increasingly lonely and in search of fleeting opportunities to bond over shared videos or escape to other worlds both real and artificial. So yes millennial investors have put a lot of money in the last 12 years into on-demand services, on-demand entertainment, 15-minute food delivery, taxi apps, micro-mobility, swiping dating apps, social amplification apps, BNPL financial engineering, Crypto speculation and the promise of escape from the whole sense deprived world via the meta-verse. Over the next few years, we will see if any of these will generate any real lasting value or commercial return, but the past 12 years also has seen an influx of capital that was directed towards investments in pioneering developments in AI, Microchip Technology, Sensor Technology, Battery Technology, Precision Medicine, Space Tech, Synthetic Biology, Computational Biology, Robotics, Alternative Energy production and just as importantly the democratisation of knowledge, the democratisation of software development (no code platforms) and the democratisation creativity and publishing, admittedly of dubious quality. Yes, a lot of these investments will also be wasted but as Bill Janeway points out “The prime virtue of the market economy is not efficiency but the ability to tolerate unavoidable waste needed in the evolution of the innovation economy.” A boom in Tech Startup valuations has meant a greater tolerance of “waste” and this as much as anything leads to investment in innovation and entrepreneurship. No waste, no failed experiments, and no failing startups equal no innovation.

But if the boom time has now ended, does investment in innovation also fall? I fear so as economist Chris Dillow pointed out in this blog “What we’re seeing, (presently in the UK economy as high inflation/high-interest rates cause consumers and businesses to spend more money on financing, rents and fuel costs) is a transfer of real resources away from competitive entrepreneurial sectors of the economy towards rentiers – those who can get rich merely by owning scarce assets such as gas and oil fields. This could reduce economic dynamism and productivity, simply as more of our spending goes on sectors with low productivity growth and less on higher-growth sectors.”

 

In recessions, investments in equities usually perform worse than other asset classes such as commodities and especially gold but this time may be different. I am not qualified to predict how high inflation, rising interest rates and hopefully the short and shallow recession will impact the prospects of startups. Of course, the impact will vary from startup to startup. Even in Business 2 Consumer markets, where the substantial reduction in disposable incomes of consumers in the U.K. and elsewhere will have a big impact on demand, there will be startups with smarts that do very well. For instance (caveat that I have invested so I am biased) I believe my portfolio company Purple Dot ‘Waitlist’ feature which allows consumers to order and pay for goods now that will be delivered months later, is for consumers a great hedge against inflation on the purchase of much-loved items. Do check them out. Others will reverse the BNPL model which I think will also do well.

What I may be able to speculate on is what will happen to investment in tech startups especially my area of interest pre-seed/ seed stage startups and especially investments in Deep Tech.

To summarise the rest of this article puts the case that the present economic conditions and the end of the 12-year boom in tech investment and valuation will make the VC model, especially the micro-fund return model, extremely difficult to pull off. I look at what drove professional investors (beyond FOMO) to feed the bubble in tech valuations and what I think happens now when economic instability puts some of those factors into reverse. To cut a long story short, if the present market correction is not short-lived (and as I write NASDAQ index is not recovering), then VCs especially micro-VCs will need to adapt their business model and practices to have any chance of making returns and this, in turn, will impact the startups that rely on them for funding. That is it. Bloody obvious really, but if you want to find out why I think that, then please do read on.

“I’m forever blowing bubbles, Pretty bubbles in the air, They fly so high, nearly reach the sky, Then like my dreams they fade and die”

From 2009 until December 2021 Nasdaq experienced a long and sustained bull market that drove a considerable amount of cash into investments in Tech companies and Tech startups. Most of that new money invested into Tech startups and scaleups (especially between 2017-2021) came from non-VC investors such as sovereign wealth funds, pension funds, asset managers, corporate treasuries and governments who for the most part are slightly more impatient or risk-averse investors than VC’s, many of them with shorter return horizons than VC usually are set up to deal with.

This occurred primarily because, as Bill Janeway writes, the purpose of “bubbles” in capitalism is to suck in speculative capital into high-risk/ low liquidity asset classes, in this case, entrepreneurs peddling the potential of new innovation, where the chances of backing failed “experiments” ( i.e. most tech startups) is much more likely than backing a winner. As Bill Janeway states, for investors in tech startups there is “a radical uncertainty (where probabilities of a favourable outcome are unknown and often incalculable) that comes with the outsized returns from making illiquid investments”. So the bubble in tech valuations directed a record amount of capital, mostly deployed by non-traditional VCs, into investments in most private tech startups. More money, leading to greater valuations, sucking in more money until …. pop.

So now the bubble of ever-rising valuations is no more, it seems that these so-called “Tourist” investors are substantially reducing their investments, especially late-stage tech startups. But investors also invested a wall of money into established VCs. This exploded the size of their funds to be used primarily for investments in later-stage funds. Furthermore, the “Bubble” also led to a much less spectacular increase in LP’s investments into new micro-funds that primarily invest in pre-Series, pre-data startups. These big and small VCs also contributed to the over-inflated valuations and consequently, now they are left with both over-priced shares in portfolio startups (who will need to grow exponentially through a recession if they and their investors are to avoid a down round on their next raise). The VCs are also sitting on a lot of “dry powder” and are facing a big decision on how to rescue their fund economics. To prevent their funds from being too concentrated in too few over-valued startups (a smaller number of investments mathematically reduces the probability of finding that unicorn fund-returner), do they cut their losses and reduce their amounts for follow-on investments and thereby invest their remaining fund’s money in a lot more startups at the present markets much lower valuations, or do they hunker down on their investments in their portfolio startups in order give them more money to ride out the market downturn/ recession until 2024 or beyond, thereby reducing their immediate losses. Of course, most VCs will try to do both, but many will not have the dry powder to do so. This article from Jason Lemkin is a good explanation of the pressure on the reserves (allocation of fund money to follow-on investments) on most micro-VC funds (funds with less than $100M AUM). This “reserve” money is needed to enable VCs to back the high-performing startups in their portfolio in order to protect their stake in that startup against excessive dilution in follow-on rounds. If there are going to be more rounds needed to get to Unicorn status or to a size that allows the early-stage investors to exit at IPO ( an increasingly rare phenomenon), then the pressure on a VC’s “reserve pot” will increase. Jason Lemkin believes that VCs will become much more selective on who in their portfolio they decide to follow. The game is afoot.

So why did these so-called professional investors, as opposed to citizen investors who the literature suggests may have been overcome by the ‘Gold/ Tulip’ fever frenzy, put more and more investment in tech startups to create this bubble in the first place? The answer is that the Tech valuation bubble and the economy that was behind it changed the calculation; changing uncertainty (unknown and incalculable) into the appearance of a risk that is calculable and knowable. For example, the long bull market for tech investments resulted in:

Enhanced Predictability of Models
The fact that persistence of low growth, low inflation, and low-interest economic conditions of the last 12 years has led to the genuine possibility that from very small data sets (such as calculating the future valuation of a SasS startup by multiplying the present ARR by their YoY growth rate) you could build a simple financial model that would enable an investor to predict the likely return on an investment (obviously discounted against the historically low inflation and interest rates). I have invested in these assumptions as the vast majority of UK investors. This accounts for the popularity of SaaS ( SaaS startups capture approximately 80% of all European investment in 2021), especially for Series A+ investors for they are far easier to model. It remains difficult for first-time founders, that do not have the credentials of previously building a successful SaaS business, to raise a seed round for a SaaS startup because they did not have the CCA, LTV, MoM growth data that enable investors to make these predictive models. The simplicity and explanatory power of even simple heuristic “rules of thumb” investment guidelines such as Point Nine’s SaaS Napkin have allowed all types of investors to gain the reassurance of being able to invest without the need for in-depth, technology, industry or market knowledge. Whether the software startup was attempting to disrupt Finance, Education, Health, Logistics or Manufacturing did not matter for the SaaS business modelling rules still applied and investors ( or the management consultant they hired) could get to work on their spreadsheets and come up with a probability of a good return on SaaS investment. All those addicted to formula-guided investments must hope that the ending of the bull market is a short-term correction and not a sign of persisting economic instability. I am fairly sure that investors’ SaaS prediction models could not cope with wild fluctuations in prices and demand and the accompanying underlying economic instability. I do believe that the 12 years of the bull market and underlying economic stability (even though the pandemic when a massive amount of government funding kept interests low, inflation under control and consumer spending) has allowed for much more formulaic investing by VCs even at seed level. Steady underlying conditions mean seed investors (including me) were confident that past performance would predict future returns, so we pilled money and created inflated valuations into Startups that were led by founders that had the experience in successfully building a startup to scale (in bull market conditions). Now the skill sets and scaling cash-guzzling playbooks of these 2nd or 3rd-time founders may not be so relevant. I would be surprised if they can continue to ask for and get their “eye-watering” large premium seed round valuations. Luckily the economic instability, which I contend is making formulaic investment decisions at least more dubious if not unhelpful, is likely to be short-lived because the instability is not caused by major (geo)political fractures …Oh hang on?

Investors reduce their demand for short-term liquidity thereby making an investment in VC and VCs investment in tech startups more attractive
Stability and duration of the prevailing low growth, low inflation, low-interest rates economic conditions and the accompanying long bull market in valuations of tech stocks allowed investors to offset the lack of liquidity in owning shares in private companies for the high expectation of bigger returns in the predictable near future. The expectation that liquidity mattered less in the short term had big implications on what investors would invest in. I think Bill Janeway again gives a good example this time in regards to investing in biotechs. “No biotech startup could be expected to reach positive cash flow from operations during the lifetime (3-5 year investment horizon) of the VC that invested in its early rounds. Investment success … (is) far more important on the varying state of the public equity markets for both primary financing and ultimate liquidity, than on the scientific and operational success of the venture”. A good friend of mine has just discovered this, as follow-on funding from his VC investors has now dried up for his Genomic biotech startup. So in this case the founder failed to get his existing investors to provide follow on investment not because his Genomic startup failed to reach impressive scientific and commercial milestones, but because the markets have fallen and thereby drastically reducing the likelihood of an IPO or pre-IPO funding liquidity event for at least the next year or two. I often hear that Deep Tech start-ups ( even those outside heavily regulated areas such as health) will be more immune from the present downturn in the economy because it will most likely take them at least two years to prove that their breakthrough technology works in the field before they can seriously commercialise. I can verify from my experience as an investor in AI startups, that two years to build the tech and prove that it works/generates real value for customers and then be ready for quick market adoption is optimistic even in the good times (compared to 6-9 months for standard rules-based software). I also know self-declared deep tech startup investors that insist that Deep Tech startups prove that they can generate significant commercial revenue within 2 years if they are going to invest. Two years seems to be the grace period before Deep Tech startups are expected to show revenue and commercial growth metrics. Even with the best intentions and a fair wind it often takes a lot of time and therefore more investor money, which means that Deep Tech startups are even more vulnerable than regular Tech Startups to a decrease in the availability and amount of external investment. After all, they cannot simply address their reliance on investors by just selling more of their under-developed/ not ready-to-sell product, or simply focus on profit to offset the risk of their not being follow-on investors around to fund the technology/ market development. This will be true for pre-seed angel and micro-VC investors who will be increasingly concerned that the “finance risk” is far higher if VCs pull back investment in the sector. It is also true for later-stage VCs who need the pre-IPO and IPO market to function for them to see a liquidity event/return within their fund’s lifetime. In this market where interest rates and inflation are rising, startups, angels, VCs and VC LPs are all going to put a higher value on liquidity. So it’s not looking good for Deep tech startups in search of investment but if you are a startup in the UK I would not despair (especially if like me you are praying/ expecting the market correction is short-lived). For there are now some more patient capital investors in the U.K.(such as Bloc and Molten) with longer-term investment horizons. Potentially there may be more government funding ( IUK, ARIA and maybe the replacement Horizon) and in certain markets, an opportunity for early exits as those corporates and investment vehicles sitting on big profits and depreciating cash piles look to acquire innovative startups for relatively low valuations. Nonetheless, Deep Tech startups, even those at the early stage, are not immune to the VC pulling back from investing and the general preference for liquidity at times of economic uncertainty and so Deep Tech startups should be expecting that it will be harder to raise and when they do that the valuations will be lower and that terms will be rewritten to protect/ favour investors. At the same time lack of liquidity on the market will mean that runways will need to be longer (consequently increasing the need for and attractiveness of non-diluting grant money). As Bill Janeway points out investment in the innovation economy is a trade-off between Liquidity and Control. And in Bear markets, those with liquidity, get control of their own destinies and control of those without…

In my view, the lower probability of receiving follow-on funding (and the higher cost and lower valuations that founders will receive) will make going for early exits more attractive to even the most ambitious founders. If this becomes a trend, then I think we will see the emergence of micro VCs able to make money from this trend of early trade exits. Assuming power law returns still pertain, then these Micro VCs with deep tech thesis will be smaller (less than $20m AUM), and have higher management fees if they need to be value adding (probably more like 5% and probable part paid by the portfolio rather than solely the LP’s), be structured that they return capital to their LP’s within 5-7 years and highly specialised, in particular, they will have a close relationship with and/or knowledge of future buyers.

Tech Bubbles lead to a greater number of “Outsized Returns” that attract more money into VCs
The explosion of Unicorns over the past 3 years and the massive growth in the amount of money invested into startups especially (those at pre-IPO that have already achieved Unicorn status) is testimony to the lure of “Outsized” returns. It stands to reason that the bigger the prize, then the bigger the risk an investor will take to grab it and the more money they will outlay. But this incentive to invest is even greater if the speed to get to the prize can be achieved in the shortest possible time and with the least amount of capital. When a SaaS startup was able to achieve a Unicorn valuation of $1 Billion on a 40-50 X multiple of its revenue (a product of VC’s drinking the exponential “kool-aid” where 2 to 3X annual growth forecast for a scaling startup carry on ad infinitum) then it stands to reason that this will take less time and less money from investors to fund startups to scale and achieve the benchmark “Unicorn” status. Yes I know I previously argued that in times of economic uncertainty, such as now, simple investment prediction models are much less reliable but that does not mean investors will still not use them. At present, when growth is going to be significantly harder to achieve, never mind the 2-3 x annual growth rates that have been typically forecasted, the revenue multiple on the market valuation for the leading SaaS companies on Nasdaq is around 3-5x, and around 10x if the startup growth prospects are outstanding. Until recently when that multiple was 40-50x, it could take less than 3-4 rounds of funding for a startup to get to a $20-25M ARR and thereby achieve Unicorn status. Now it will take more rounds and more money thereby making the economics of the micro-VC model even harder to make work. If it will take more time and more money to reach unicorn status means the VC need to be bigger, have more money under management and probably be more patient. If this becomes the norm then it will radically change the behaviour of early-stage investors. If I was running a micro VC now I would definitely be trying to get a greater stake from my first cheques investments in startups (somewhere near 20% rather than 10%) and hope this protects my fund from excessive dilution from the extra rounds of finance a successful VC backed startup will now have to plan for. If the power-law distribution of returns pertains, the business model of Micro VCs is under serious threat and therefore rather than blindly following the models and playbooks of the larger well financed VCs, I believe they will need to innovate on their business and operation models unless (as many must hope) this market correction is short-lived.

[I do feel that much of the billions of dollars dry powder in sidebar VC growth funds and in Big VCs will not actually be used to fund the late-stage follow-on rounds of scaling tech startups. Instead, I forecast it will be used to refinance and restructure the broken over-valued balance sheets of otherwise viable businesses. This is what I believe Sequoia and its confederate funds have recently done with Klarna when they invested almost $700m at a valuation of $6.6m post money in their latest fundraising this summer. This was as an 87% fall in valuation for Klarna on their previous 2021 $45.5m valuation, no doubt wiping out many of their early-stage investors. When there is no or little chance of achieving liquidity from an IPO, there will still be companies, who may with a little financial re-engineering be in a position to become cashflow positive, who will voluntarily choose to sell stock at a significant discount on the last valuation in order to buy time and more certainty. In these cases, there will certainly be money to be made from investing in the down rounds as long as the market recovery and the subsequent rise in valuation are not too far away. Obviously for earlier-stage investors, a down-round especially one the size experienced by Klarna brings little joy or respite].

 

I really do not want to add to the gloom for Micro VC. Still, all these factors plus added ones such as the ‘Denominator effect’ are making it increasingly difficult for both first-time and 2nd-time funds (who if they invested heavily in seed to series A deals between 2020-22 will find almost all their investments are facing markdowns) to raise from LP’s. The impact will start to be seen by startups in 2023-2024. When they go fundraising they may find a reduction in the number of seed to A stage-focused investors writing cheques.

So, my conclusion is if the public market valuations for tech stocks do not bottom out this Autumn/ winter and if the high inflation, high-interest rates persist through to 2024 and beyond thereby resulting in a subsequent year-long recession and a persisting cost of living crisis (and not just in the UK), then Micro VC business models will need to substantially change. Adapt or die or pray (I am doing at least one of these) that the market correction ends soon.

Forever blowing bubbles…