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Young VCs are about to take their biggest test

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Between 2009 and 2021, the stock market enjoyed its longest bull market ever, with returns over 400%. But what goes up must come down. While the economy managed to recover quickly from the immediate crash caused by Covid-19, it appears that we are now experiencing a real downturn – meaning an entire generation is about to experience a bear market for the first time.

This will likely come as a shock to many home traders, but the impact will be particularly brutal for venture capital investors. After years of successful “picking winners” that then delivered impressive returns (especially in the technology sector), these investors are about to discover just how good they really are. Do they do their due diligence on market fundamentals, or did they just follow the trends and get away with it? The coming months and years are about to turn into some serious reality check.

Related: How (and When) to Save During an Economic Downturn

Is the tech bubble bursting?

In recent years, any discussion of “high-growth stocks” or “industries to watch” has largely focused on technology in its many forms: fintech, Software-as-a-service (SaaS), cleantech. But now these sectors are experiencing the most painful decline.

The stock market is going down about 18% overall (give or take a few percentage points depending on the day), and technology stocks are down nearly 30%. Considering these tech companies made up about 25% of the S&P 500 in 2021, they’re not just falling faster than anything else — they’re a major factor in why the stock market is falling in general. The Tiger Global Fund, for example, which focuses on the internet, software and fintech sectors, lost 52% only in the past year.

So what’s going on? When the pandemic first hit, software solutions suddenly became a critical part of everyday life and the workplace, forcing individuals and businesses to go truly digital. Share prices shot up for companies like Zoom and Netflix, and 2490 companies reached so-called unicorn status in the first six months of 2021 alone (meaning valuations of $1 billion or more). Moreover, this all happened against the backdrop of 10+ years of low interest rates.

But with inflation rising and a correction taking place, it seems the market has become over-excited, with many tech companies overvalued due to pure speculation. For example, Zoom went from a stock price of $73 in January 2020 to $349 a year later – and now it’s back to $109.

Some have compared the current situation until the so-called dot-com bubble of the early 2000s, where many investors put their money into just about every internet-related company in the hope that they would become “the next big thing”, despite some of those companies without a real value proposition. Pets.com is the classic example.

As before, investors have stuck huge amounts of money into business models and sectors that they always really understand (Web 3.0, anyone?), and the economy is finally catching up. In addition, recent trades have taken “forward-looking” valuations to a whole new level, leaving investors hyper-focused on specific startup categories (such as SAAS) that tend to trade high earnings multiples, creating a plethora of overvalued startups that are expanding their product-market. have not always validated fit or have a path to a solid business model – not to mention profitability or a decent runway.

Related: How to Invest Smarter and Safer in the Stock Market?

What it means for investors

Venture capital investors have one main goal: to identify and invest young companies with high growth potential with the hope of making big profits later. In recent years, “big gains” have been mainly associated with the tech industry, especially after the digital acceleration brought about by the pandemic. Suddenly, it didn’t take much for tech companies to secure good valuations, regardless of whether they had really good market fundamentals – so it didn’t exactly take a genius investment strategy to achieve impressive returns.

As this trend continued over time, investor confidence grew and some became more careless. They may have forgotten that all the buzz was a bubble, or maybe they just didn’t care. Because as long as valuations continued to rise in subsequent rounds of financing, all was well in the world of illiquid assets.

In 2021, VC exit values reached $774 billion in the US, and venture capital outperformed all other asset classes. But now that the heyday is finally coming to an end, dumb luck and riding the wave won’t cut it.

In the coming years, the investors who win will be the ones who have done their due diligence – those who, rather than simply following in the crowd, have explored crucial market fundamentals such as a company’s product, market validation, management, business model, etc. Not to mention those who were fiscally responsible enough to put money aside for tougher times and maintain a decent runway.

Related: Telltale Signs You Shouldn’t Raise Venture Capital

What will the future bring?

The current downward trends of the market are not just pure speculation. Inflation is currently high (8.3% between April 2021 and April 2022), which reduces the purchasing power of both consumers and businesses and makes it more difficult to sell. It also makes it harder for companies to budget and plan for the future.

With interest rates rising to fight inflation, borrowing is more expensive than before, which will obviously lead to lower valuations and a more difficult environment, at least for the foreseeable future. Interest rates have been one of the key drivers of growth in the first place, so they will be a critical factor in changing the environment.

But there’s also a lot to be optimistic about – the downtrend is likely a temporary burst, rather than a bubble bursting. The role of the internet is now cemented, technology isn’t going anywhere and so there will always be valuable technology stocks and companies that will continue to provide fundamental value.

While some companies (and maybe even funds) will fall, this is actually a healthy correction for the market in general. Solid companies with a good product that solve an important problem still have room. In addition, companies with strong management that know how to adapt to the markets and optimize for the long term are likely to do well in the long run and will have the unique opportunity to increase their market share if their competitors fall away. After all, while many companies fared poorly during the dotcom crash, there were also quite a few that survived and continued to thrive, such as Amazon, eBay, and PayPal.

Today’s young venture capitalists better hope they are one step ahead of their competitors. Those who have done their homework, those who have done due diligence, developed an investment thesis, and have not completely ignored the fundamentals can do well, while others can sit in hot water. Either way, for both VC’s startups, this will likely separate the men from the boys, resulting in a stronger and healthier economy.

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