Economic Downturns Mark a Return to Sanity (and Returns) for Venture Capital

The dot-com bubble was a speculative bubble created by a rapid rise and interest in internet companies. This five-year period leading up to the peak in March 2000, saw many companies focused primarily on gaining market share through brand building and networking.

The name of the game was getting big fast, as companies raced to acquire larger market share, sacrificing profitability for growth. The dot-com boom pushed the Nasdaq Composite Index to an all-time high of 5,048.62 on March 10, 2000.

Then, just like that, the bubble burst (as they all eventually do), and one company after another imploded — fueling an internet sector freefall that lasted for the following two and a half years. In the end, the Nasdaq lost 78% of its value.

Businesses and investors realized that large investments and rushing to IPO does not compensate for a lack of a sound business model. With the spectacular rise and colossal crash of many dot-com companies, only a few were left standing — becoming some of the most well-known companies in the world. Companies like Amazon, eBay and Shutterfly were lucky, as well as the investors and venture capital (VC) firms that invested in them.

Venture Capital’s New Downturn Opportunity

In 2023 and it’s almost as if all you need to do is substitute the dates and replace “Internet” with “crypto or blockchain” and we’re re-living the same old story. Over the past year cryptocurrency prices have dropped by more than 75% and the colossal collapse of many crypto-focused companies like Terra-Luna, Celsius, BlockFi and FTX. In parallel, many other crypto players are running into difficulties and are laying off employees, cutting budgets and reducing revenue projections.

While the crypto crash has been the hot topic and lead headline, there’s no denying that significant economic headwinds exist throughout the economy — exaggerating the current trends in tech, Web3, crypto and other high-growth, early-stage industries.

Whether it’s a bubble or a recession, are today’s economic woes similar to the crashes of old?

Similarities to the Dot-Com Era Burst

1. Both involve new and emerging technologies that have attracted significant attention and investment from VCs and other investors.

2. Both involve a high degree of speculation and risk, as these technologies are still in the early stages of development and adoption.

3. Both were characterized by a period of extreme hype and speculation, expectations detached from reality, which led to skyrocketing valuations for companies in the sector.

4. Both were fueled in part by a wave of new investors entering the market, many of whom were driven by the prospect of making quick and easy profits.

5. The two periods saw a similar magnitude of value drop — well over a 70% drop in Bitcoin price during this crypto winter vs. 77% drop in the NASDAQ composite index during the dot com era.

6. For VCs, both periods saw a shift in VC investment focus towards more mature, revenue-generating companies, rather than earlier-stage startups with unproven business models. There was also increased competition among VC firms to invest in the most promising companies, leading to higher valuations and larger funding rounds.

However, there are some significant differences between today’s market conditions and the dot-com era and even the Great Recession of 2008. Differences that create unique challenges, along with positive opportunities.

Differences From the Dot-Com Era:

1. The dot-com bubble was largely centered around traditional tech companies that were building new businesses and products, while the current blockchain and crypto boom is focused more on decentralized technologies and digital assets.

2. The dot-com bubble was largely driven by retail investors, while the current crypto boom has attracted a more diverse group of investors, including venture capital firms and other institutional investors.

3. The dot-com bubble burst was largely driven by the failure of individual companies, while the current situation for blockchain and cryptocurrency investments is more complex and involves a range of different factors, including regulatory developments, fraud and mismanagement, market trends, and technological advancements.

4. The impact of the dot-com bubble burst was more widespread, impacting not just the companies and investors involved, but also the overall economy. The crypto crash impacts a smaller segment of investors and organizations with exposure to crypto.

What Does This Mean for VC Investing in A New Economic Era?

Some of the strongest vintages in private equity and venture capital were recession years; the dot-com crash of the 2001 period, for example, produced the best performing vintage in more than 20 years. However, beyond significant market corrections and the ability of smart VCs to get in on the ground floor of transformative startups, other factors that have contributed to private equity’s success in times of crisis include active involvement with portfolio companies, the ability to deploy capital more flexibly and the ability to insulate investors from panic selling. Additionally, seasoned VC leaders understand the importance of staying the course, being confident in your strategy and continuing to invest in promising companies, even during times of economic uncertainty.

Nevertheless, maybe more critical than any factor is that serious economic corrections breed more due diligence in the VC world. I recently wrote a piece about how the time it takes a VC fund to move from the discovery phase to the final investment phase has drastically shrunk in the last few years. There’s been a feeding frenzy to find a unicorn in just about anything — creating a culture of shortcuts and trigger-happy investing.

Specifically, the crypto crash and the resulting “crypto winter” (along with a variety of other economic factors) has forced many funds to slow down and take a deeper look at companies, their leaders and the inner workings of each startup they are courting. Instead of the feeding frenzies of the pre-2021 VC investing, sanity will return and instead of deals getting done in days and weeks, it will be months or longer.

Moreover, while much of the VC “hype” has been focused on crypto, there has been an entire universe built on blockchain technology that is experiencing incredible growth. Blockchain technology will endure and is already reshaping many large industries like capital markets, banking, insurance, healthcare, supply chain, and gaming. As such, VC funding has been shifting away from centralized crypto lenders and exchanges and taking a hard look at Web3 and blockchain-focused companies.

VCs Will Continue to Help Fund and Grow our Digital Economy

Overall, similarly to the post-dot-com bubble burst, VC firms that stick to their strategy, become more selective and make intelligent decisions about where they’re putting their money — investing in strong companies with sound teams and business models that are set to weather and navigate the current difficult times — are set to benefit from the continued growth of the ecosystem. Plus, let’s not forget that entrepreneurs never pause for down markets and neither will VC funding of their innovation.

Originally published at https://www.thestreet.com on January 18, 2023.