Traffic Jam Lessons 🛣
How Startups & VCs Can Navigate Roadblocks
Roadblocks on the investment highway: Investors have long fought over the most promising startups, but now many venture capitalists are investing significantly less, and some not at all. How has the ecosystem stalled and what are the implications for European startups?
Startups and traffic jams — what does our startup ecosystem have to do with highways?
Traffic jams. We’ve all experienced them — sitting in your car on the highway and going nowhere. The startup and VC ecosystem is experiencing a similar situation at the moment. ‘Traffic‘ isn’t at a complete standstill yet, but things are only moving forward at a very slow pedestrian pace.
If you see a traffic jam up ahead, you slow down or stop entirely
Far-reaching economic events such as inflation, unfavorable interest rate policies and geopolitical challenges have brought about a shift in investor sentiment. Initially this was apparent in public capital markets; subsequently this shift was felt in the upstream private venture capital markets. Investor reluctance triggers lower valuations, resulting in better investment opportunities, but also poorer venture capital performance. This makes fundraising more difficult and further constricts the supply of capital. Venture capitalists increasingly focus their scarce capital on their own portfolios as a result and this culminates in a ‘traffic jam’.
Traffic jams on the investment highway: from deluge to funding drought
When Kağan Sümer raised nearly one billion US dollars with Gorillas in a Series C funding round not all that long ago (September 2021), it was raining investment money for many delivery companies. SaaS companies, logistics companies and fintechs were also experiencing the highest valuations yet and investors often fought over the most promising teams of founders. This was the situation before the funding drought.
Today things are different. Investors are reluctant and startups suddenly have to make do with less capital over a longer period. It is no longer volume growth alone that counts, but potential profitability that is as timely and credible as possible while the fledgling companies are pre-profit. To achieve this, these companies have had to cut costs and created crisis-resistant frameworks and business models. Existing financial backers are providing the majority of the funds.
In the absence of new investors, subsequent funding rounds with existing investors are generally based on the same terms as the previous round — ‘flat rounds’ — or are based on less favorable terms — ‘down rounds’. Prior rounds are also usually devalued retrospectively (anti-dilution protection) resulting in existing shares losing further value. The situation becomes even more challenging for companies, when individual funds stop investing altogether. This process means that even some of the most successful startups that got off to a great start, but which are dependent on follow-on funding, can falter.
Times of crisis do pose great opportunity, however.
Times of crisis do pose great opportunity, however. Startups are stress-tested — if they can reposition themselves and optimize expenditures, they will emerge more resilient into a competitive environment that is noticeably less congested. They continue to mature and continuously build up intrinsic value — even if their external valuation has decreased in the meantime. Downturns also create new investment opportunities for investors, who can make promising investments at more favorable valuations.
Light at the end of the tunnel — the traffic jam is easing
It is precisely this that constitutes the hero stories of the ups and downs in the startup ecosystem. VC companies that muster the courage to continue investing in times of crisis are ultimately responsible for relieving pressure on those still in the game. They observe great success with the investments acquired cheaply during the crisis when the first light peeps through at the end of the capital market tunnel. The first venture cars on the investment highway are noticeably picking up speed and gradually lightening the capital market mood. Other investors are slowly becoming more confident, and the ecosystem is gaining momentum once more.
Based on recent years, we know that cyclical downturns generally last two to three years from the initial slowdown through to recovery. This was the case with the dotcom crisis in 2000 and the financial crisis in 2008 — and it will be the case again this time. Upswing phases, however, are more varied in their duration and depend on the timing of the drastic events that lead to the change in sentiment on the markets previously described.
Europe’s startups will not experience a crash as severe as that at the turn of the millennium. Our system of startups and venture capitalists is now so large and stable that there will be no innovation landscape collapse. There will be a separation however — not everyone will survive the current downturn. At the end of this ‘traffic jam’ a strengthened ecosystem will emerge, more stable and resilient than before. This is not the time to duck out, but to look forward courageously and set our sights on new horizons, with the lessons learnt from the last traffic jam safely stored in your trunk.
By Dr. Hendrik Brandis, Co-founder & Partner, Earlybird Venture Capital
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