Global Recession & Venture Capital Winter | A Macro Perspective
A Playbook for startups operating in Venture Funding Winters — Part I
We are in for a winter (slow down) in the VC space and it is going to be freezing. A generation of entrepreneurs have, in fact, never witnessed a down market and our startup ecosystem must come out of its exuberance and face the harsh reality.
In this 3 part series, we will understand the macro factors affecting the global economy negatively, how the VC world is reacting to such quick changes, and how a startup should plan its future course till the market improves.
When it comes to the economy, the writing has been on the wall for the last few quarters. All major indicators are red.
- Inflation (CPI) at a 40-year high after a decade long cheap money:
Historically, the Fed has used the interest rate as a lever to reduce inflation. Fed’s interest rates track inflation very closely and have helped in ensuring a softer exit from the 2008 financial crisis. Unfortunately, this time around the Fed waited a way too long time (see fig. below) to stop Quantitative Easing (printing money by the central bank and ultra low-interest rates) inadvertently leading to a lot of cheap money in the market.
Since the 2008 financial crisis, an entire generation (Millennials) has never seen interest rates above 3% and by the same token has never seen inflation above 5%.
Even the Fed agrees that it will not be a comfortable journey and some pains in the short term are inevitable.
2. Stocks movement in negative direction due to diminishing present value:
Stock prices have a negative correlation with interest rates and stock prices usually go down as interest rates increases. This happens for two main reasons:
- Debt fund rates or bank savings rates increase making these safer investments more attractive for people
- Net Present Value (NPV) of the stock decreases when the interest rate increases. A higher interest rate leads to a higher discount rate which when used to divide the total cashflow expectation makes the current Stock Price value lower
Unfortunately, the increase in interest rates has a doubling impact on growth stocks. Growth stocks are essentially tech stocks whose earning capabilities are mostly into the future. Since the time horizon for growth stocks to return profits is longer, the expected NPV value is severely affected leading to a greater drop in Stock price vs. value stocks (which offer a consistent revenue stream albeit with lower growth rates).
This year's data shows how growth stocks are getting plummeted in the public markets. The Nasdaq, a proxy for valuations of tech companies in the US, is down 25% so far this year with prominent Corona-era companies such as Netflix and Zoom down 70% and 50% YTD respectively. Zoom currently is currently at a lower market cap. vs pre-pandemic times.
Additionally, the exuberance in the market by investors has been detrimental. Investors assumed that the pandemic would change lives forever. They believed that we would keep watching more Netflix, keep buying groceries online, and keep ordering food online. Investors extrapolated trends that started in the pandemic and assumed that these trends would continue to grow in the future. But as the pandemic has started to fade, people have resumed some of their pre-pandemic habits. This gets reflected in the stock values of pandemic favored stocks, e.g., Door Dash, the online food delivery startup, whose stocks are down ~50% year to date.
3. Declining confidence in startups leading to declining Public Market Multiples:
Usually, public market multiples are a strong signal of how venture companies will be able to do an IPO and approximate their exit returns. Thus a decline in public company multiples will reflect in the IPO valuation of these private companies. SAAS companies are among the most inert industries against recession since enterprise (B2B) sales slow down post direct consumer sales. So you would see FMCG, retail, consumer electronics, etc. types of industries de-grow first.
5 years ago, the median SAAS enterprise multiple (Enterprise Value / ARR) was running at 5X of ARR (normal multiples). During the pandemic with cheap money available the ARR multiples for high growth SAAS companies went up as high as 35X which currently are at 8X now. The median multiples have returned to 5.6X which represents a 2/3rd correction in valuation (15X to 5.6 X) for these companies. Imagine the valuation drop other consumer-centric or pandemic boosted industries would be facing.
4. The Consumer credit bubble is approaching:
The consumer aspect was holding up the economy to a good extent. We currently are at an all-time high consumer credit card debt at $930 billion. At the peak of the 2008 financial crisis, debt was at $870 billion. With interest rates going up, personal consumption costs will go up. Additionally, Younger Americans (18 to 29) have a 76% higher delinquency rate, higher than anyone else and real wage hourly earnings decreased by 2.6 % vs last year too. With a significant wealth erosion in the market (14% of global wealth lost YTD), companies are going to tighten the belt with a focus on reducing costs which will inadvertently lead to a hiring squeeze and loss of jobs.
We are in for a prolonged winter and it will impact the whole economy. Some key trends shaping this are:
- High inflation & increasing Fed interest rates
- Public stocks losing value due to perceived risk and increasing rates
- A decline in public market multiples leading to a loss in private valuations
- Tipping consumer debt and risk of personal credit default
Lastly the gamut of uncertainty in the global market:
- A war going on
- COVID pandemic still alive
- Supply chain problems in China
In the next part, we will discuss how these macro factors affect the venture capital market and how the VCs will respond to it. Stay tuned….
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