After the Storm: A Better Startup World

Part 3: What will be the wider impact of a bust in startup valuations? Scroll down for parts 1 and 2.

A quick reminder. Private investment dominates the current boom in startup funding. Public traded stocks play a much smaller role than in the past. For example in the dotcom bubble most  big companies went to IPO. One point of view is that this will contain the impact. A lot of private investors will lose money. But the fallout for the general economy will be small.

I don’t think this will happen. I will explain at the end why this will be a good thing. But warning this next bit is a real downer.

“There are some things you learn best in calm, and some in storm”
Willa Cather

Playing for High Stakes

For a start there is just too much money involved. Mattermark identified more than $100 Billion of US investment over 10 years. This only covers rounds over $100 million. Globally the numbers are huge. The private investment factor amplifies the pain of losing. There is no liquidity in private markets. Investors cannot bail out if they see the downturn coming. Or even after it has hit. No-one can cut their losses and run into safe havens. Mark Cuban made this point in a recent post. 

Startups are not a portfolio

A bigger factor is the herd mentality. Most other assets classes offer shocking performance. Big institutional investors are counting on startup investments to beef up their total returns. Much of the money derives from the same sources that piled into sub prime and the like. The problem is that institutional investment tends to adopt a herd mentality. It doesn’t matter if they are right or wrong. Too many investment adopt the same strategy. This makes the whole system vulnerable to shocks.

This factor is also amplified. In this case by a misunderstanding of portfolio risk. You will see a lot of advice about the risk of investing in early stage companies. Invest in a large number of opportunities and the big winners will offset the wipeouts. Build a portfolio they say. This is not a portfolio. This is a buying a lot of tickets for the lottery. It may well work and it has for many funds. But it is not spreading risk. Every investment just adds another high risk. Pick enough and one will pay off is the theory.

The problem arises when the lottery stops paying out. There is no balance in the portfolio. Everything turns bad. Remember this is how it will be. Even the big quoted companies destined to join the corporate elite will experience large falls in value.

Its not just about the money

Lets not forget that it is not all about finance. A downturn in startups will also have wide impacts because this stuff matters. People and businesses rely on the software startups produce. The network feeds itself and consumers love it when it does. Enterprises are creating massive value by using mobile and digital to do business better. Mobile money, mobile health and green startups are changing the world. If some of these companies fail, people will care.

Big knock on effects are possible. Many apps interconnect through APIs. Your business does not just depend on the software you have. Other applications and data sources are integrated. Sometimes these are invisible to the user. Consumers are in the same position. 

A Matrix of Possible Outcomes

So what will the impact look like? This is harder to understand. We understand how a big bust in public markets transmits to the wider economy. Because this is a bit different, the mechanism is less well understood. In reality we don’t know. What follows is educated speculation. I have not attempted a systemic analysis just picked out some specific possibilities.

• There will be one or more serious big time scandals. These could be corporate, financial or governmental. One real possibility is that a company will go bust leaving a whole lot of private data open for predators.
• The economy will take a genuine hit.
• This will be amplified for quoted companies. Liquidity will be a disadvantage. Investors can dump public stocks with ease.
• Governments will decide there is a need to regulate the private investment market. This will impose costs and risks on funds at the worst possible time.
• Investors will lose even more money in fees to reallocate their portfolios. There will be a stampede of investment managers advising a rush to the next fad.
• People will start shouting about the importance of digital connections. And bleating for state subsidies.
• A lot of smartasses will appear on TV explaining that business hasn’t changed. The whole digital revolution is just a mirage etc. This is a certainty. Don’t bother punching them on the nose. Just laugh.
• Governments will use this as an excuse to regulate and restrict social media. This will be nasty and anti democratic. No laughing matter.
• Lots of countries offer big support for startups today. Some of these schemes and grants will disappear. Government can be as a short term as any investor. 
• Real issues of trust will arise. There will be pain if services shut down. This will be hard to combat. Teams need to take this seriously. We all owe our customers a duty of care.
• The cloud will take a battering. Some of the customers who lose out will blame the cloud (wrong). Legacy IT companies will jump in to argue that private infrastructure is safer and more secure. This will be another tough fight.
• When the dust settles the global landscape might look very different. Asia and Africa are already the wellspring of our most innovative thinking. A startup downturn could be the catalyst for developing world to overtake the West.

Green Shoots

But the tech industry will emerge stronger and better from everything that happens. A startup valuation bust will be a beautiful thing for entrepreneurs as I wrote in part 1. It will also be great for the whole ecosystem. A downturn is a real opportunity for innovation. The best ideas emerge from the furnace of hard times. 

• Big losses will force investors and business leaders to think different about business finance. The first sign will be a more favourable climate of debt financing. Interest rates will be rising again (see part 2). There will be new instruments and access to debt will be much easier.
• Investors will also start to understand that some technology needs long term finance. Time defined VC funds will not die. But we will see more evergreen finance. A new fund called Indie VC is already leading the way.
• The quality that software delivers to customers will also be transformed. Only startups with a genuine and sustained passion for solving customer problems will survive. The get rich quick schemes and the use it because its cool apps will disappear. The reputation of the whole industry will benefit.
• A personal hope. The survivors will be scattered across the globe. Silicon Valley will still be strong but it will suffer. We will have the chance to build a more global and supportive ecosystem.

New Horizons

There will also be big opportunities for individual entrepreneurs and investors. Remember two basic principles:

• Buy when everyone else is selling.
• The time to grow market share is in a downturn.

The startup ecosystem will shrink a bit. Those who are left will be the people with real vision and passion. A few years after the bust the industry that emerges will be bigger stronger and better than ever before.

Writing these articles has reminded me I love startups. A real focus on change for the better and a great ecosystem of people to work with. These basics will not change if times get tough. 

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