What type of startups might we see in the future?
This article holds some of my thoughts on how high-interest rates might change the type of tech companies built by the next generation of founders.
The Past
Before discussing the future, let’s talk a bit about the past. Since 2011, there’s been a meteoric rise in venture capital funding. In 2021 alone, American VCs invested nearly $350bn in startups. Excitement about technology or solving problems aren’t the only reasons for this drive. Another reason is low-interest rates. Because the venture capital asset class typically drove higher returns on investments than other assets, many investors wanted to reap the benefits. Please note that I will use US numbers as a proxy in this article — it’s the world’s largest technology market, and many global tech companies and investors domicile in the US.
These low-interest rates led to more and more money for VC fund managers and, in turn, more money for startups. During this time, some truly crazy things happened. Here are some headlines from this period. Walk with me.
It’s not just that VCs were pouring so much money into the tech sector. Startups were raising money rapidly — in a frenzy. Clubhouse launched in 2020 and, by April 2021, had a $4bn valuation with $0 in revenue. Clubhouse is one of the finer examples; many other companies had unfavourable unit economics and were held up and continually funded by VCs, while the startups subsidised life for millions of people. Asides from private markets(shares in early companies and VC are often private), the public market was booming — 2021 saw a peak of 1035 IPOs. Not only were VCs pouring into private markets, but the public markets were also rewarding these companies with so much cash. The rationale of VCs was this: “If I invest in a company early, I could make a lot of money if it goes public via an IPO and if it goes public fast.
By the end of 2021, things started to change. First, many of these startups began to crash — so much money had been invested and hadn’t brought commensurate returns to investors. In early 2022, the world started to see rising inflation for different reasons(post-COVID, the war in Ukraine, supply chain shortages, too much money, etc.). To stem inflation, The United States Federal Reserve Board(The Fed) increased interest rates to combat inflation.
Remember when I said people flocked to VC to reap better returns? Well, there was no need to do this anymore. Investors could give their governments money, take lower risks and get good enough returns. It also became clear that many companies that VCs were funding had terrible ideas, were poorly managed, or didn’t make sense. And so there’s been a reset.
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The Present
Here are some headlines from this year:
VC funding in Indian startups drops by 74.6%
Global VC funding dropped to $18 billion last month
VC funding in Nigeria plunges 92.1% in Q1 2023
It’s clear as day that the success of the computing technology industry and software’s impact on the world was grossly overestimated and, in some continents, rushed. Maybe not every tech company needs to be scaled beyond measure with world domination in their sights. And just maybe, the global economy can only sustain a reasonable number of unicorns.
This venture capital slump has led to companies shutting down because they can’t raise more money to stay alive, staff getting laid off, and investors cutting their losses.
The Future
Based on the above, here‘s what I think the future looks like for the tech industry:
- Not all industries or aspects of life need any computing impact — software or hardware. Some things are just fine, as inefficient and annoying as they are.
- Not all companies need to be fast-growing startups raising money every quarter. When I worked in VC, this was common feedback we gave entrepreneurs.
- There are many industries and opportunities for computers to impact work and life, but many aren’t billion-dollar opportunities. Some opportunities require a few people to build software that earns $1K-$10K-$100K-$1M ARR. Small teams of people can manage these companies and run them profitably without external funding. Like Lenny says here, the fact that a market is small doesn’t mean entrepreneurs shouldn’t pursue solving problems in that market. Big things aren’t the only things worth building.
- Markets aren’t equal. In some countries like Nigeria, companies that are not fully software-based have raised a lot of money. The effect is that some human(or other physical) element of their business slows growth, which naturally means the current valuations are too high. Since the marginal costs of software aren’t tending towards 0, there’s no need for pure software valuations and multiples.
- Retail companies selling their brands of shoes, clothes, luggage, or a mattress shouldn’t carry valuations like software companies. Owning an e-commerce website and holding ‘user data’ doesn’t make a company a software company. Yes, even if the company built their e-commerce site.
- Like the dot-com boom, we might see another generation of investors again throw money into the technology sector. Technology remains exciting and shiny for many investors.
- Many industries continue to be impacted by computing technology. Despite layoffs, there’s still a massive opportunity for another generation of tech workers in many industries. Workers with tech skills will remain highly sought after and highly paid.
- Many technology companies need longer-time horizons from inception to scale. Investors, founders and employees need to be more patient. It does take time to build any respectable multinational company.
- AI companies are hot, raising much cash with unproven business models. There’ll always be hot spikes that seem to buck the trend.
- The venture capital asset structure expects only a few companies to succeed. VCs will reduce risk by investing less cash, but the business model requires risk, so VCs will continue to take risks by investing in new technology companies.
In conclusion, on the one hand, the venture capital downturn has exposed a lot of shaky and weak business models and poor products. On the other hand, it has created many opportunities for new technology companies with solid fundamentals to emerge. Some of the most exciting companies that exist today launched during downturns. I’m very excited to see where the market leads.
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