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What Happens To Startups In The Next Recession?6 min read

John Loeber is a software engineer and angel investor based in San Francisco.

There’s a party going on. We are in the ninth year of the post-recession bull market; the S&P 500 is up over 300 percent; capital is flooding into technology ventures; and startups are raising more money at valuations greater than ever before, except for the peak of the dot-com bubble. But what happens when the music stops?

These days, the average successful startup takes about eight years to exit. We also see a bear market (a 20%+ drop in the stock market) every eight years on average, sometimes coinciding with an economic recession. So it seems likely for startups to eventually be caught in an economic downturn. Startup founders should anticipate needing to weather such conditions, and startup employees should consider macroeconomic uncertainty in valuing their stock options. We’ll reason about what the exact effects of a downturn will look like.

We can expect that an economic downturn first affects the public stock markets. Tech stocks are generally high beta, meaning they swing more than the market, and they generally trade at high price/earnings ratios, meaning that investors expect great earnings in the future. However, when the market dips, these great future earnings suddenly seem much less certain, and investors flee those stocks. This happened in 2008: even though its earnings weren’t greatly affected, Apple, Microsoft, and Google’s stock prices all lost over 50%.

If public tech valuations suffer, then private ones will, too, because public valuations act as benchmarks for what private ones might reach. If public valuations are down 25 percent across the board, then a tech company attempting to go public would see its target price similarly slashed. Or a public company may use its stock to acquire a private company1; therefore, when stock prices are down, a public company has less liquid assets to conduct acquisitions, meaning the private company might have to reduce its valuation to be acquired at all. And when late-stage valuations come down in private markets, then early-stage valuations necessarily do, too, since expected exit values decrease.

Early-stage valuations would also suffer because the cost of capital increases. Most venture capital funds raise frequently—roughly every two to four years. In a (prolonged) downturn, it seems likely that high-risk, high-reward venture capital funds become less attractive to investors2. When VCs have a harder time accessing capital, there’s less for them to invest in startups, and the capital they do have on hand would likely be invested more conservatively. This means that raising capital would generally be more expensive for startups: VCs would demand more equity, startups would raise less money per round, and valuations will be lighter.

This spells existential trouble for many startups. Paul Graham likes to differentiate between startups that are default-dead and default-alive. A company is default-dead if they need to raise more money to survive; otherwise, they’ll run out of cash and declare bankruptcy. In 2018, a great number of startups are default-dead. There’s been a great proliferation of these default-dead startups in recent years, because venture financing has been so easily accessible.

For example, Postmates or WeWork can post losses for years on end, subsidizing user growth in the hopes of ultimately flipping the profit-switch and making huge profits on tiny margins at gargantuan scale. Most startups that I know are unprofitable in this way, and project being unprofitable for the foreseeable future, such that they definitely need the next round of financing to survive.

These default-dead companies don’t have a lot of runway either. Conventional wisdom is to raise about every 18 months, which implies that most startups never have more than two years of cash in the bank. A given startup in this cycle might have a year’s worth of runway in the bank. So if valuations suddenly tank, these startups are going to be in serious trouble due to a lack of time and difficulty in fundraising. Some may even perish in the absence of cheap capital.

However, for most startups, a harsher fundraising environment means raising money on worse terms. Practically speaking, it means that startups will raise down rounds at valuations smaller than what previous raises commanded. Critically, down rounds severely diminish the value of the common stock. Most venture investments are made with anti-dilution protections, which means that prior investors (owners of preferred stock) will get to own proportionally more of a company if it undergoes a down round. It is the holders of common stock/options—founders and employees of the company—who bear the brunt of the financial loss in this case. Employees usually own options, which have a strike price: a price the employee needs to pay in order to turn the option into stock. It’s not uncommon to see a down round leave shares valued close to or below the strike, making the employee’s option package worthless3.

This has troubling implications for startup employees, because stock options are usually sold to them as a major part of their compensation, and startups should expect an economic downturn before an exit. If you work at a default-dead startup that needs to raise another round, then the big question is whether your company will raise the round before the next economic downturn (and whether it will then have enough cash to weather the storm or reach profitability)4. If not, and your startup is forced to raise a down round, then the value of your options is on the line.

These implications are ultimately also troubling for the less well-positioned VCs: there may come a day when their entire portfolio of default-dead companies gets marked down by a double-digit percentage. The model of VC-subsidized startup growth, while deferring immediate profitability, is a precarious dance. We don’t know exactly when the next macroeconomic downturn will strike, but default-dead startups, their investors, and most of all, their employees, may come to find they’ve been climbing a house of cards.

  1. This is especially critical in today’s startup market, since acquisitions by blue-chip companies have become a cornerstone of exit strategies.

  2. Because public equities are on discount, while the valuations of the VC’s portfolio companies will be heavily marked down. It’s likely poorly positioned VC funds will shut their doors altogether.

  3. One complication is that most startup employees have nowhere near the information to assess those cases. They almost certainly don’t know the terms their company raised on. Even elementary figures like the most recent valuation are often not known by employees.

  4. Furthermore, it’s worth keeping in mind that in a market downturn, consumer activity slows. Startups that are default-alive right now would become default-dead in a downturn because its market will have shrunk.

The post What Happens To Startups In The Next Recession? appeared first on Crunchbase News.

Source: Crunchbase


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