There is no question that the 2022-2023 economic bender has impacted startups. The mere fact that interest rates have been ballooning is enough to change the economics of venture capital, and the failure of Silicon Valley Bank didn’t help either. Now, we’re starting to see questions about the thing that VCs adore above all else, the exit strategy.
Every startup is funded on the assumption that it will make a profit for its investors, the “angels” and VCs that provide the initial capital. Even those who elect to start a company or participate in a new one are usually lured by the hope of making a killing on “the exit”. The exit, of course, means sale of the company to a major player or a successful initial public offering (IPO). The problem is that exit values have been plummeting, with 2022 looking bad, and 2023 looking really bad. Everyone involved wants to see a reversal of this trend, but that’s going to be difficult without an understanding of what’s causing it, and even then it may be that the causal factors really can’t be reversed. We might well have been in a venture bubble.
I’ve worked with tech startups for decades, and over that period there are things that have remained fairly constant for the space and things that have changed, sometimes radically. From the very first, the startup and VC space has been focused on generating buzz, or hype. A startup is a quick way of entering a market area, so if there’s potential for a new product or service, the VCs will try to plant their flag there and exploit it. However, it doesn’t take rocket science to understand that a big company could easily commit the same resource level (or more) to a tech area and build their own stuff there, given the time. Thus, a big part of startup-think is to create the perception that there is no time, that the new area is hot right now and those who hesitate (and try to do it themselves) are lost.
Shortly after the VC space really got going, I saw the growth of a related concept, the idea that buzz was furthered by competition. If you’re a widget startup, you need to promote yourself for sure, but you also need to promote widgets. A “new” hot product area has to be validated or the whole startup thing is a waste of time because nobody will buy in. Having multiple startups in a space spreads the cost of validating the space among the group, and the competition among those startups gets the media excited. There have been stories of back-room VC deals where a group of VCs agree to pool ideas, with each having an opportunity to be the winner in a space but requiring them to take a secondary position in promoting other spaces with an entry, knowing other VCs would win there. Needless to say, the amount of hype increased here, and has increased ever since.
By the end of the decade of the 2000s, it was clear that VC returns were less rosy and there was more and more interest in creating companies on a shoestring. Social media provided the opportunity. You don’t build a product, you launch a website. Amazon’s AWS was the favored platform for these social-media startups because they expensed the software and hosting rather than having to buy capital equipment and build data centers. By 2010 it was harder to fund “product” startups, and today we obviously still see things favoring the social-and-Internet startup types.
There’s an underlying problem behind all of this, though. Any “market” has a saturation point. There is a limit to the amount that will be spent on routers, servers, toothpaste, and deodorant. There’s also a limited amount that will be spent on startups. In the social media area, one thing that defined the last two years was the realization that social media and Internet giants like Alphabet/Google, Facebook/Meta, and Twitter were showing signs of hitting the wall. Servers and network gear also seemed under pressure, and from where we sit in 2023 all that seems self-evident. That’s what is creating the startup pressure, because it threatens the exit strategies.
So what now? If we go back to my market-saturation point, one thing we have to accept is that it’s not possible to say that we can somehow radically increase the amount of toothpaste or routers people will buy. If you want to make more money, it’s best to open a market area that’s not already at or approaching saturation. Ad-sponsored OTT services are there. The only thing you could hope to do is to steal market share, and that’s a very complex, time-consuming, and expensive proposition that frankly isn’t all that appealing to VCs.
The problem is that it’s likely that any new market area will be more expensive, more time-consuming, and more complex than VCs have become accustomed to dealing with. If we were to explore the product startups in the tech space, we’d see that the majority of those founded over the last five years have favored spending additional funding rounds on sales/marketing rather than on product development. While the VCs have always favored startups with “laser focus” to contain costs and risks, that’s become an obsession today. They want a concept that’s largely complete and they want their startup to play it, not improve or advance it. Money to market and sell can pour in, but time is also passing. The problem is that if success takes long enough, the underlying product concept can run out of gas. Valuations, the implied value of a company created when a new funding round is closed, can rise and rise until there’s no exit possible because the concept isn’t valuable enough.
That’s what creates the real risk to “unicorn” startups, one that have been successful in raising a boatload of money and generating a high implied valuation. Prior to COVID we were in a period of some market exuberance. Tech, during COVID, was a bright spot because work-from-home and stay-at-home generated tech-centric needs. Now we’re past that, and so exuberance has faded, and startups and their concepts will have to deliver in the real world. That’s the bad news; returning to reality is always a shock.
The good news is that there’s reality to return to. As I’ve pointed out, between the consumer space and the business space, we have nearly a trillion dollars in addressable benefits to justify additional spending. The problem is defining ways of addressing those benefits and getting the money they represent. That this can’t be done (easily or perhaps at all) using current paradigms should be obvious; we would have done it already.
My personal view is that the largest single opportunity set associated with that trillion dollars is that of “digital twin” metaverses, but there are a lot of experienced and talented software architects out there who may have another, better, idea. My main point is that the best place to direct new projects to get at that money would be the place that gave you the most money from a single concept.
AI is an example on both the positive and negative side. Anyone who doesn’t believe AI is important is deluding themselves, but so is anyone who believes it’s not already overhyped. The danger in hype, for startups and for the market, is that it easily diverts efforts and funding from spaces that could be highly valuable to those that are simply eye candy. I think we can assume that there will be dozens of AI startups. I’m confident that most of them will fail, and it’s likely IMHO that the AI bubble will only make exit strategies harder in the long run.
For companies who have already launched, and who may right now be contemplating what to do about an exit strategy, my recommendation is to look for credible technology extensions that would open new opportunity areas. In a financially constrained market of any sort, you want to be an “evolutionary revolutionary”, someone who extends a credible and visible concept in an arresting new way. There are opportunities to do that out there too.
Doing nothing at this point is not an option. “Waiting for recovery” as a choice presupposes not only that there will be one (there will be) but also that the recovery will return us to the familiar and comfortable status quo, and it will not. The outlines of the future are visible now, but the future isn’t the present, or the past, and a startup/unicorn who believes that is exposed to a terrible risk.