Startup Funding: A Cork Bobbing On The Ocean

The cackle and chat about a potential startup valuation bubble has risen again in 2016. I wrote 3 posts about this 10 months ago and I am not sure too much has changed. I still don’t know when there will be a correction or what the trigger will be. But there are clear risks and the outcomes are hard to predict.
 
This post is not going to pretend to be an analysis of the scene. Much smarter people than me are providing that insight. I just want to reflect on a few basics and some scenarios which seem to be missing from most of the commentary. 
 
First thing is to get real about the markets in which startup investing plays a part. The Big Short is an excellent book and no doubt a good movie. It is not a substitute for understanding. According to Fortune  funding for VC backed startups was $128.7Bn in 2015. With a sharp fall in the final quarter). By contrast the falls in Wall Street alone in 2016 so far are valued at around $1Trillion. Add in China and other markets and that loss could be $5Trillion.
 
Startup investing, even at epic levels, is a cork bobbing in the ocean of global markets. If we want to figure out what might happen next we need to think outside the closed world of the startup ecosystem. The same applies when we ask ourselves what the impact of a bust in startup valuations might look like.

Movement in public markets creates pressure in both directions

Tom Tunguz is a reliable source of real data analysis in the SaaS world. This recent post  points out that price falls in public markets create some downward pressure on late stage valuations.
 
However, market movements are not as simple as this. Investor returns from public markets and many other asset classes are at historic lows. As I pointed out last year this makes startups look like an attractive option. Mahesh Vellanki has reinforced this point here.  Economic pressure on traditional investments drives startup values higher. By increasing the demand from large investors. 
 
Of course this would change if market drama turns into real economic crisis. 

Internal strains and pressures

Global markets are not going to be the immediate cause of a bust in the startup bubble. What about internal strains of the ecosystem? This is where most of the commentary focuses in both directions. Insiders offer a wide range of opinions. Including Jason Calacanis who believes that any bubble has already been deflated. In a controlled fashion without anyone noticing.
 
Maybe investors are not as much in control as this article implies. There are more opinions than Republican candidates. And this could be sign of internal strains. That might just lead to a bust from within the startup universe. What would the impacts look like?

• Entrepreneurs would get hurt. One point everyone understands. Cash will be king. Startups with money in the bank have the opportunity to survive and thrive. Anyone without will risk being swept away by the tide.
• In theory, angel investors will be fine. No-one should put money into high risk, early stage business unless they can afford to lose. In practice, I suspect there will be some casualties. 
• Some VCs will also be in trouble. The VC model depends on confidence. Any fund that loses confidence and has cash in the bank that investors can pull out faces a problem.
• Many large  VCs and large financial institutions are a big part of late stage rounds. They will be suffer no more than a blip. In part because the money these funds have in startups is small by their standards. And also because they are playing with other people’s money. But watch these funds nonetheless. They can affect the wider world as well.

 
As a founder the message is proceed with care. If you cash you will be in a strong position. Competition may weaken and talent could become easier and cheaper to hire. But it will take time to get out of the woods so husband your resources. And watch out for ultra lean competitors. There will be startups out there innovating with high skills and motivation but no money. 

Customer trust is everyone's responsibility

The big risk in this internal scenario is loss of customer trust. If high profile startups with strong consumer brands fail this will cause widespread damage. For example, imagine a cloud service that holds precious family photographs disappears. Or an accommodation service goes under and leaves people without accommodation for the holidays. 
 
In these situations a high percentage of the media will be eager to blame “the cloud” and “the internet” and “ global companies that don’t pay tax”. Whatever the truth, the road will become much tougher for early stage SaaS.

Could a startup bust go viral?

The level of startup investment is small compared to global markets. You might think the internal impacts are the end of the story. Not necessarily so. There are a couple of ways a fall in startup valuations could trigger wider consequences.
 
Quoted stock markets had an indifferent year in 2015. Even before the sharp falls that have kicked off this year. This lacklustre performance two big swings. On the downside oil, mining and other commodity related stocks. Falls there have been more than offset by rapid growth in the FANGs. Another corny acronym which stands for Facebook, Amazon, Netflix, Google.
 
None of these companies has the most transparent financial disclosures. So it is tough to tell whether they have a high dependence on startups or not. On the other hand I know that a big part of the money flowing into startups is going out on marketing expenses. And a lot of those dollars go to Facebook and Google advertising. How vulnerable is the revenue growth of these companies? It would only take a small surprise to knock market confidence.

Trust is not just for customers

The other factor in grown up markets will be the behaviour of large investors. Remember, the guys whop play with other people’s money. Public opinion is still hyper sensitive to any hint of mistreatment for small investors. A perception that losses in high risk startups are being offloaded will be a big issue.  Small pension holders or taxpayers cannot foot the bill. 
 
Crowdfunded investments could create a special case of risk. Equity crowdfunding is quite new in the US but has been around in the UK for a while. Regulation is light and risks are high. 

Stand up and be counted

Loss of trust either from customers or the wider public is a real possibility. It will present a massive challenge for fragile startup businesses. Trust can only be won back by consistent, authentic ethical behaviour. One of the things I love most about the startup ecosystem is the high standards of ethics. These are almost universal. The true test of such values will only come when they are under threat.
 
No-one knows whether or when a correction in startup valuations might happen. If it does you will need to be prepared to look after your own business. The wider effects could be no more than a ripple. Or not. Beware the signs of a gathering storm.