During the stock market mayhem this week, you would be forgiven for missing a significant anniversary.
On Tuesday, it was 20 years since the Nasdaq reached its dotcom peak. The rot that set in after that date makes this month’s market correction look small beer — at least so far. The main index of tech stocks fell 77 per cent in the dotcom bust.
Since then, an entire generation of tech entrepreneurs has come of age without any serious interruption to Silicon Valley’s long boom. Capital has been abundant. Even the financial crisis of 2008/9 turned out to be a blip: venture capital investment dipped in the following 12 months but quickly came back stronger than ever.
A serious correction has felt overdue for years. But the low-growth, easy-money decade turned out to be a perfect environment for tech start-ups. Among investors, it created a hunger for the type of growth that only tech companies could offer, along with a ready supply of capital to act as rocket fuel.
So is the Covid-19 scare the moment this finally comes to an end?
The demand shock from the pandemic poses a severe threat to thinly capitalised companies across the economy, and tech start-ups, which typically live from one funding round to the next, are no exception.
Sequoia Capital sounded the alarm a week ago, writing to entrepreneurs it had funded to warn them about the need to reassess. Given the severity of the market gyrations since then, Sequoia’s email has started to look surprisingly mild. Nudging start-ups to trim expenses hardly looks draconian amid an unprecedented freeze in some sectors of the economy, and with no way of assessing how long the crisis will run.
This raises two overriding questions for start-ups. One is how steeply demand will fall off in the short term.
In the consumer economy, a drastic change in how people live their lives, combined with a heightened caution about making longer term commitments, throws many business plans in the air. Picking over the pluses and minuses is complex. The “gig economy”, for instance, might prove a lifeline for consumers who are practising social distancing and need to tap a range of essential services. But large parts of it are also tied to sectors such as transport and travel that are suffering the most.
Tech companies that sell to businesses should be able to count on more dependable revenues, particularly given a shift from transactional sales to subscriptions with the rise of cloud computing.
But this picture is more complex than it may look. Many new software-as-a-service companies have found a ready market among other start-ups. It makes much more sense for a new company starting with a blank sheet of paper to tap into variable-cost cloud services, at least compared with an established company with sunk costs in its existing IT. Moving into the so-called enterprise market of big business and government customers takes time and heavy marketing spending.
There are echoes here of the dotcom crash, when much of the revenue recorded by new internet companies represented sales to their peers, all of it fuelled by venture capital dollars. If the start-up economy falters, many of today’s new business-to-business tech firms will also feel the pain.
The other big question concerns access to capital. Some recent trends, such as a rise in the use of venture debt, are likely to come to a screeching halt. Sceptics who warned that a sudden change in the economy could leave indebted start-ups exposed have every reason to feel smug.
The steady increase in the size of venture funding rounds in recent years should be grounds for optimism. Many founders have justified taking money they didn’t immediately need with the argument that it made sense to raise cash while they could.
Often, though, spending has risen in line with the capital on offer. This represents an entirely rational response by tech entrepreneurs. Investors have rewarded growth above all, so it made sense to ramp up marketing budgets to hit the most ambitious targets. As Sequoia warned entrepreneurs last week, the expected lifetime value of those customers may not be what it seems, particularly when the economy turns down.
Unlike the dotcoms, today’s tech start-ups can usually point to a sound business model and real end-demand for their services. But they have also been pumped up by heavy marketing, and the ultimate scale — and value — of their businesses may be a lot lower than it looks.
Beyond the immediate crisis, it is possible to see a continuation of the conditions that have served the tech start-up world so well. With monetary authorities around the world struggling to contain the crisis, capital is likely to remain cheap and plentiful. In a world desperate for growth, investors will be even more dependent on the next promising start-up unicorn.
But it is impossible to tell how severe the crisis will get, or how many of today’s promising tech start-ups will make it to that next sunny upland.