A Brief History of Bubbles and Crashes.
Taking a step back and understanding where we currently stand.
Except if you spent the last few months on an island (or in the desert), you probably heard that the market is crashing, or that founders are increasingly facing difficulties when trying to raise money. Some people in the tech/venture sphere even made parallels with the dot-com bubble of the 2000s. 🚨
Yet, this sort of gloomy situation is completely new for all of those among us who discovered tech post-2008 (and we know we’re a large majority!). 🙋♀️
In fact, down-rounds were not really part of our vocabulary until recently, and we were getting used to valuations relatively decorrelated from startups’ economic reality (remember the 50x or 100x revenue multiples from 2021). 😅
All that introductory blabla to say the team wanted to leverage this second longer piece (after a first one about Revenue-Based Financing a few months ago) to provide all of us with (i) an historical flashback to the 2001 Dot-Com Bubble, and (ii) with answers to a set of key questions about what’s currently happening in the ecosystem exactly. We hope you’ll enjoy the piece. So now, let’s dive in! 🤿
Part I: A First Stop by the 2001 Dot-Com Bubble.
The Dot-Com Bubble… As just mentioned, some people seem (or have seemed) to be pointing to this crisis arguing that 2022 constituted a similar situation.
More broadly, this dot-com crash often seems to be referred to as a foundational step in tech’s broad history. So let’s try to get a sense of what this was all about. And let’s start with some basic Wikipedia definition:
Indeed, our Brief History of the Dot-Com Bubble starts during the 1990s, a decade that witnessed some unprecedented technological innovations, starting with the birth of the first web browsers. In 1993 especially, a browser called Mosaic was released and became one of the very first web browsers to be widely available. For the record, you can note that Mosaic’s two co-founders were Eric Bina and Marc Andresseen (yes, the Marc Andresseen). 🕵️♂️
What the release of Mosaic meant was that internet adoption was ready for its takeoff. And indeed, from 1990 to 2000, the number of internet users in the U.S. grew from nearly 0 to 125m+ people, meaning that by 2000, almost half of the U.S. population was accessing information through the internet. 📺
In turn, this also meant the dot-com concept was born: you could from then on buy an online domain and upload your website. Here again, figures are self-explanatory:
From 1991 to 1995, the number of uploaded internet website went from 1 to 23,500,
From 1995 to 1996, it jumped from 23,500 to 257,601 (!!).
Thus, many entrepreneurs understood the field of opportunity this new dot-com concept had created, and decided to launch so-called dot-com companies and leveraged the nascent web to sell products. That’s typically the moment when Amazon (1994) and Ebay (1995) were born. 👶🏼
Another key milestone took place in 1995, the year when Netscape went public (another company co-founded by Marc Andreessen, and that also developed a web browser). On the day of its IPO, the price went up from $28 per share to $58. Note that this was unprecedented for a company which had been founded 18 months prior to its IPO. And this insane soar in the valuation (from 0 to +$2b) more than caught the attention of investors.
A gold rush towards tech companies had started, and impressive amounts of money started to be poured into them — often at the cost of investors' former discipline around valuation multiples. By 1999, some stocks had raised +1,000%. 📈
While all that hype was taking place, a neglected pickle was that many of these newly public companies were not earning a single profit (yes, that’s a very big pickle, we agree).
For example, Amazon (which had gone public in 1997 already had a valuation of over $14 billion in 1998, but was still not profitable). 😅
But again, the hype was phenomenal, and all that mattered was getting bigger and bigger. On March 10th, 2000, the NASDAQ reached an all-time high of 5132.52 points.
On our way to the burst… A 5-steps timeline.
1. On March 13th 2000, Japan announced it was entering a recession.
This was a critical event as Japan was a crucial player in the tech market and this announcement kickstarted a worldwide sell-off of tech stocks. 📉
2. On March 20th 2000, the FED raised interest rates.
And this is important because, remember: as interest rates go up, tech stocks will always go down. This is a basic principle: the value of tech stocks usually lies in the promise of future revenue, and the time value of money changes with higher interest rates. 💲
3. On April 14, 2000, the Nasdaq Composite index had already fallen 9%, ending a week in which it fell 25%. 📉
4. In Spring 2000, Microsoft was facing an antitrust lawsuit.
The U.S. government was accusing Microsoft of illegally maintaining its monopoly position in the PC market and this through the restrictions it put on the ability of PC manufacturers and users to uninstall internet explorer. Failed early settlement of the case led to a 15% drop on Microsoft stocks and a 8% drop on the Nasdaq (its fifth-largest percentage drop at that time). 📉
It was around that moment financial analysts were seriously starting to raise red flags regarding tech stocks and that they started to dig into those tech companies’ financial reports. As they were doing so, confidence rapidly and seriously further declined. 😬
5. By the end of 2000, most Internet stocks had declined in value by 75% from their highs.
$1.755 trillion in value had been wiped out, and the NASDAQ fell by 39% that year alone (for comparison purposes, the Nasdaq lost around 30% in March 2020 and regained them only in a few weeks). Many companies went out of business, including many public companies which sometimes had IPOed only a few months before.
Yes, but…
Although a large number of companies went bankrupt, some literally blossomed. And here, we can name drop Amazon, eBay or Google among the lucky few which leveraged the post-burst period to engage in a consolidation effort. 🏄♂️
In fact, these companies had an advantage in this harsh context as real estate was cheap, labor was plentiful and less expensive (the dot-com crash had caused more than 22,000 people to lose their jobs), and the competition became limited.
For sure, their stocks were hurt (Amazon went from above $5 per share down to almost $0.3). But with brilliant people on their teams and solid business models, the fundamentals were there, and they managed to more than recover. We only need to look back at their full trajectory to see how this crash only turned into a small bump on the road.
With all that background set, let’s now fast forward to nowadays! 🕰
Part II: October 2022, where do we stand?
A few metrics.
Let’s start with a purely quantitative look at the current situation. A first metric that is relevant to take a look at is the Cloud Index (EMCLOUD), an index created in 2013 by Bessemer Venture Partners, an American VC firm, and which tracks the performance of emerging cloud software public companies. As of Friday Oct. 21 2022, this index is down 60% compared to November 2021 (source: Nasdaq).
Then, another metric worth-observing is that of the number of IPOs, especially in the U.S., which is home to the two largest stock exchanges (NYSE and Nasdaq).
Clearly, we can see that after a record year in 2021, 2022 is on track to be a much gloomier year. 😕
Last but not least, the same pullback holds true for the total venture funding amount in 2022.
All in all, total venture funding was down by $90 billion (53%) year over year for Q3 2022, and by $40 billion (33%) quarter over quarter.
So, this is where we stand. But the next question is: how did we end up here?
The pandemic and its impacts. First, and as the pandemic accelerated the digital transformation of many industries, we know that revenue growth rapidly increased for many startups, and this led to an inflation in valuations as investors wanted to secure their slice of the cake. 🍰
In parallel, developed economies seriously helped sustain consumption, wages and corporate balance sheets through their Central banks, and through massive cash overflows. This surge in available capital ended up fueling further startups’ revenue growth as well as valuation inflation through increased investments in tech.
Increased availability of capital, decreased risk-aversion. As capital became more largely available following the outbreak of the pandemic, and as valuations started to get increasingly inflated, this led some founders and investors to make huge returns in a relatively short period of time. In turn, the propensity of these investors to put their money in high-risk (or possibly, completely speculative) projects increased (e.g remember the Bored Ape Yacht Club launched in 2021), fueling further the inflation feedback loop. 😅
But history showed us how overheating must come to an end at some point — or possibly burst. And this is exactly what happened in 2022. 🧭
The main difference between the 2001 dot-com crash and today’s situation.
Although a similar pattern has clearly repeated itself (a bubble… and then a burst), there are two critical difference we can highlight:
First, the fact that the need for tech products and services is now well established and that many of publicly traded tech companies today are actual companies. In 2021, the U.S. tech industry employed an estimated 5.8 million people (i.e. 4% of total U.S. employment), according to the Computing Technology Industry Association.
Second, it can be argued that the inflated valuations of B2B companies in 2021 could at least be partially justified by the SaaS and Cloud major growth trend, a trend that did not exist in 2000/1 and that made stellar valuations even less justified.
In short: we have today a similar pattern, but with nuances to be brought compared to 2001. Now, let’s move on to the practical implications this situation will have for entrepreneurs and the ecosystem. 🔍
The impact of the current downturn on entrepreneurs & the tech ecosystem.
First, the clearest impact is the lower valuations currently applied to tech startups. This is readily visible when looking at the events surrounding some of the most valuable startup companies. Instacart, the U.S. grocery delivery app, had to cut its valuation earlier this year by 40%, and announced it would lower it a 3rd time this week. Klarna, the Swedish buy-now-pay-later scale-up, raised a notorious down round in July whereby its valuation shrunk by more than 80%, from $46bn to $.7bn. But the correction in valuations is also visible for startups at the earlier stages. As the cost of capital rises, investors naturally become more cautious. They are not competing to fund early-stage rounds with the same ferocity as in 2021 and therefore, valuations do not balloon as much as before.
Ultimately, the impact is clearly on the negative side for entrepreneurs as funding rounds will become smaller and dilutions will go up. Eventually, not every entrepreneur will be able to raise money for their venture.
Another expected effect for startup founders trying to raise is the comeback of the flat and down rounds (as we just saw with Klarna for example). For someone who has discovered tech only around or after Covid-19, there is no such concept of a tech startup not raising a subsequent financing round that is substantially larger than the previous one. But in years prior, flat and down rounds were not so uncommon. Of course, raising a down round is not any founder's preferred way to go, but leading investors suggest that this is a much better option than holding on to an unrealistic valuation — as the latter eventually results in a disaster for the venture.
It’s also likely that some investors will equally struggle. One expectation is that fund sizes will stop climbing and may even generally reduce in size. While in the last couple of years, VCs were popping up with a similar rate to startups, the next few years will be different. Just as not every young venture will be able to raise money, so will some VCs struggle to close their funds. Still, the message from the top U.S. investors for startups to buckle up for turmoil has also been filled with hope, as VCs have ensured their investment vehicles are always ready to deploy capital to outstanding ventures. And while this last bit might sound only like a nice story to tell aspiring founders, it might just make sense. For the ecosystem as a whole, the situation might not be so grim after all. 👀
Will everyone be impacted the same?
For one, not everyone will be impacted the same. For example, the late-stage side of the ecosystem (both entrepreneurs and investors) are expected to be significantly more affected by the downturn. Why? In a nutshell, there are limited exit opportunities for VCs. As the public market contracts, investors realise that their exit window is currently virtually closed. We saw earlier how IPO in the U.S. have significantly decreased in 2022. Such a trend makes investors more cautious as the upside, meaning cashing in on their investment through an IPO, is presently limited.
On the early-stage side, the situation is not as worrisome as later in the stage funnel. That said, valuations are getting cut here as well and VCs are not making as many deals as in 2021. Perhaps one the largest upsides of this downturn on early-stage startups comes from human capital. The great talents being laid off by tech giants and scale-ups alike might well turn into unicorn builders in the upcoming months/years. Whether they found a venture themselves or join another early-stage startup, great operators will be more available than ever. 📈
There is a reason why, as the saying goes, "the best companies are built in times of economic uncertainty". At the end of the day, despite all the science that has been put into it, great talent is the main secret (not-so-secret) ingredient to any great startup. 👨🍳
Thus, and although with some adjustments, life on the early-stage side goes on. But don't get it wrong: early-stage venture-capital will still remain risky, uncertain and overly dynamic — that said, all those factors are why VCs entered this game in the first place after all!
The same way great startups are built during downturns, so can great investors prosper when not all seems well. There will be choices to be made within VC portfolios: which companies to back in order to extend their runway — and which not. Placing those bets correctly could result in significant upside for investors. As discussed above, flat rounds and down rounds will be likely, and existing investors will have to make the choice whether to participate or not. If they do and end up recapping the right company, they could end up owning more of a successful venture. As exit time will come, they will cash in handsomely on shares which have been bought at a discount back in the times of economic downturn.
Also, what all seems to indicate is a certain DISCIPLINE comeback. Over 2020 and 2021, VCs had to (almost literally) fight for the good deals: great founders were showered with presents and ended up receiving dozens of term sheets from AAA investors. Rather often during those hectic months of abundant capital, VCs were able to do only limited due diligence (DD) and sometimes were even investing because of FOMO on the next unicorn. The days of no DD and closing deals in days are likely to be over because of this economic downturn. Of course, the competition will remain fierce for the best deals, but investors will now have more time to do their work. Proper DD will make a comeback with customer interviews, revenue and expense examination, deep understanding of the sales cycles, reference calls, and more. Such more detailed work from the investor side will likely lead to more diligent business fundamentals on the side of the founders. 📝
So, as you can see, an economic downturn is not all bad news. There are upsides for those entrepreneurs and investors who know their fundamentals and remain flexible with their plans in the face of uncertainty.
Ok, but how long will this downturn last? 🙁
Without any surprise: we can solely rely on predictions here. 🔮
But in a recent live event organized by Eldorado, Xavier Lazarus (Managing Partner @ Elaia) expressed his conviction that this gloomy period will probably last for another 18 months, with another challenging year in 2023, and then a possible improvement that will be highly correlated to the situation in Ukraine and other macro factors that are difficult to predict. He also pointed out that what is even more difficult to predict according to him is the impact this period will have on people's mindsets – an impact which might be much longer. 🧠
So, with all that written, we hope we managed to bring some light to where the ecosystem currently stands, and to what the historical background many people refer to looks like. Lastly, we leave you with the hopeful note that inspiring entrepreneurs will continue building great companies, smart investors will still back them, and that the startup ecosystem will emerge stronger from the surrounding uncertainty! So let’s all keep optimistic and enthusiastic! 🚀
If you have any feedback, please reach out at: joinbabyvc@gmail.com. 💌
And happy Sunday! Take care! 💛
Super interesting!