Author: Patricio Hunt, Managing Partner of Intelectium
The reality is extremely complex and there are many forces at play, but by simplifying this complexity a little, I will try to give my point of view and reach a concrete answer.
To begin with, Is it true that we are facing a very important change in the economic cycle. The combination of strong economic stimuli as a result of the Pandemic, and the war in Ukraine, have resulted in a double demand shock that, on the one hand, has caused a lack of supply and bottlenecks in production chains and, on the other hand, a sharp increase in the prices of commodities and energy.
This context causes prices to rise beyond what we have been used to in recent decades in developed markets.. When inflation soars to such high levels, the economy's relative prices are distorted, as some change very quickly (food, for example) and others more slowly (wages). This leaves winners and losers in the economy and generates social conflicts that can have serious consequences in terms of growth. Therefore, economists have come to the conclusion that the healthy thing is that inflation does not exceed the 2% threshold. For this to happen, central banks must act by raising interest rates, and the risk of this is that they will rise at such a rate as to paralyze growth and add the economy to a recession.
But this is not just here, in the current context there is another fear... and that is that the increase in rates will not be able to contain inflation (because energy prices have other drivers) therefore, and simultaneously, we are entering a recession. This is technically called stagflation and hasn't happened since the '70s. It is difficult to predict if this will happen or not... therefore, there is uncertainty and in the face of it certain decisions (flight to quality) are accelerated and others are slowed down (investments), and as a result economies slow down. In other words, no matter what you look at, we are doomed to an environment of lower growth or directly recession, that's clear.
How does this affect startups?
The first thing in macroeconomic terms is that, As stock markets fall, institutional investors see these investments in their portfolios diminished as a percentage, and therefore, unintentionally, they have more investment in alternative assets in their portfolios than they had planned... This paralyzes investments in alternative assets, such as venture capital, because without intending to do so, they have been overexposed to these assets. Ergo, it will be much more difficult to raise new venture capital funds in the coming years. Ello Alone causes VCs to become much more selective when it comes to investing, because only a very good performance will allow them to raise more money later on.
In addition, since they expect economies to slow down, everyone looks much more skeptically at the financial projections of entrepreneurs... And that causes startups have the best operating accounts and the best balance sheets, regardless of the ones that are going to be prioritized in their investment decisions.
For this reason, VCs like Sequoia are working with their top entrepreneurs in a combination of cost adjustments and raising capital at whatever price (i.e. debt at higher rates or equity at lower valuations than they were). And this is what all startups should be doing right now, that is, preparing for the worst, stretching their “runways” to the maximum possible to get through the next several negative months that await us soon without the need for capital.
The good news for startups is that VCs have raised a lot of capital until very recently, when it was abundant in the markets, and in most cases they have to invest it over the next 4 or 5 years. This is very positive because it means that startups that base their growth on good “fundamentals” will not have it so difficult to fund themselves. But it is also true that those startups that moved into growth territory at all costs, regardless of their capacity to generate cash in the short term, will have a very difficult time overcoming this stage.
