China’s ‘Black Monday’, as financial pundits have unimaginatively come to refer to it, was an economic cataclysm. Let’s list the reasons:
- The Shanghai Stock Exchange Composite Index has dropped over 40% from its peak in June.
- Global stocks have lost an accumulative $5 trillion since August.
- The Chinese government has scrambled — and ultimately failed — to stem its markets from haemorrhaging any further; for that matter, most experts don’t have much faith in their counterparts to exercise any real control in this crisis.
- China’s economy, the engine for global economic growth but sustained by a property bubble fuelled by a tremendous amount of debt, is looking increasingly shaky, and pundits are split on whether this is merely a short-term correction or the first sign of a long, painful return to Earth for Chinese markets (and prices).
Or as Chicken Little might characteristically proclaim:
“Holy shit you guys,
Indeed, some financial pundits are already predicting economic nuclear armageddon. Whether it’s short-term volatility or the beginning of something much more serious, the consequences will likely be felt for some time, especially if China’s economic weaknesses exposed by the downturn are deeper than previously realised: liquidity might dry up; risk appetite could go down; allocations may become more conservative. The breadth and duration of these consequences are difficult to fathom, let alone predict.
But one thing almost certainly is true:
In the event of nuclear economic armageddon, unicorns might just return to being an endangered species once more, and the only things left will be cockroaches and early-stage startups.
You don’t need to look any further than where the money is coming from, and — more importantly — where it disappeared following Black Monday.
The gargantuan, grandiose late-stage funding rounds you often hear in the news — “Uber raises $1B from Microsoft”; Snapchat raises $500M from Fidelity Investments”; “Xiaomi raises $1.1B from GIC”; ad nauseum — are not being raised from traditional tech funds. Instead, they’ve been raised from non-traditional capital.
These are your sovereign wealth funds; your pension funds; family offices; corporates; hedge funds; and private banks.
These funds are more widely leveraged than typical venture capital funds, especially those focusing almost exclusively on technology. Where your typical Sequoias, Formation 8s, and Accels might be vulnerable to a downturn in a given sector if their respective portfolios are overexposed, that vulnerability is still relatively confined to technology, the time horizons of these funds are usually long enough to outlast any short-term volatility, and even for those funds focused on a specific niche, say fintech, hardware, or IoT, those funds are still diversified across numerous investments.
The non-traditional funds behind these late-stage rounds, on the other hand, are leveraged across a number of widely different sectors, industries, and markets, making them particularly vulnerable to global downturns. The time-horizons on their investments are much shorter, in many cases pre-IPO, making them far more susceptible to short-term fluctuations in global economic growth; finally, and perhaps most importantly, these funds have been absolutely flush with cash.
The reasons for this are numerous, and not the point of this column, but much of it can be attributed to relatively low interest rates, not only in China, but also the United States, the UK, and elsewhere. When interest rates are low, the cost to borrow money decreases. The simple consequence is that a tremendous amount of new capital flows into the economy. In the case of late-stage financiers, a good portion of that wealth poured into technology companies like Uber, Snapchat, and WeWork.
And those companies needed it.
Why not go public? Well, for companies with severe regulatory hurdles, uneven (or even lacking) profitability, and breathtaking monthly cash-burn (or almost every unicorn on this list), that’s not easy. In fact, it’s impossible for a lot of these unicorns to go public at their current prices, because the market simply cannot sustain them. So while tech IPOs dry up, private markets continue to grow.
Why go through the painful, tedious, byzantine process of becoming a publicly-traded company when you have three separate funds pounding your door asking for the chance to write you a US$500M check?
But as I’ve written before, taking private, late-stage money is the equivalent of strapping a rocket on the hood of a car and overshooting your exit by a hundred miles. Larger rounds bring larger valuations, and it becomes harder and harder to go public.
And that’s what the world was like when #BlackMonday hit.
Before the crash, capital was easy to come by. After the crash, who knows?
In the worst case scenario, late-stage companies may no longer be able to raise any more capital, because that would either require new investors willing to invest at an even higher meteoric valuation, or current shareholders swallowing the bitter pill of a down round when a company raises at a valuation less than the one established in previous rounds. Both scenarios put them further and further away from a profitable exit, and as the economic world potentially crumbles around them, they might be more inclined to bunker down and sit on their money while they still can.
Funding, especially late-stage funding, dries up, and companies are faced with the unenviable position of *gasp* finally growing profits to make their valuations even remotely justifiable before going public, or face a haircut they won’t soon forget. Many of these companies will not be able to survive as the full weight of their financial position collapses on their shoulders.
Bill Gurley, partner at Benchmark, an SV-based VC firm, hit the nail on the head:
If the economic repercussions of #BlackMonday aren’t prolonged, then there’s a slight chance that late-stage financiers will shake this one off and continue their high-spending ways. But if China’s economy, which powers a significant chunk of the world economy, really starts to flag, then watch out: there’s going to be a seismic shift in late-stage financing. Many unicorns simply will not survive.
But there’s hope.
If and when the towers of sky-high valuations and torrid burn rates collapse onto themselves, all that’s going to emerge from the rubble are early-stage startups.
Startups raising now, at relatively conservative check sizes, will still be able to do so, at least for the short-term and especially if the downturn isn’t as bad as some expect. Regardless of the economic environment, negotiating the difference between US$5 million and US$10 million is much simpler than negotiating the difference between a US$5 billion and US$10 billion. The risk appetite of early-stage funds will still be robust, albeit tempered; even the end of the world wouldn’t keep early-stage investors from trying to find the next home run.
But startups can still get squashed.
As startups mature and grow from seed to Series A and beyond, there will be less patience for outsized valuations, especially if those valuations cannot be reasonably tied to revenues.
Startups can no longer rely on investors mindlessly agreeing to tremendously high prices simply because the potential is there.
While growth will still be a remarkable resilient metric from which VCs will gauge a startup’s potential, profitability will become more important, especially if the economic downturn is more prolonged. The earlier you are, the easier time you’ll have keeping the focus on potential and raising off of that, but that conversation might soon change the larger (and more expensive) you become.
So, early-stage startups: chin up, the sky might be falling, but it’ll land on others long before it lands on you.
As for funds, well … 2016 is going to be an interesting year to raise!