2021 was a record year for VC investment and startups found fertile ground to multiply, grow, and thrive. VC investment nearly doubled and was the highest performing private capital asset class. In 2021, 200 European startups reached unicorn status (compared to 167 in 2020).
However, just a year later, this prosperous paradigm shifted. During the first semester of 2022, the stock market experienced the lowest values in the last four decades. There’s debate over whether we’re heading toward a market crash or a full-blown recession, which increases the uncertainty around market volatility.
Markets are living organisms that operate in cycles. Fluctuations and downturns are normal occurrences. However, they can lead to investors panicking and choosing safer investments. As we’ve clarified, investing in startups is considered risky investment. Therefore, early-stage startup founders may find it particularly difficult to find investors for their fundraisers during a market downturn, or they may find themselves with no other option than to give up more equity than they initially planned.
As a startup founder, particularly for early-stage startups, navigating the market fluctuations is an added stressor to the already demanding responsibility of leading the foundational stages of a growing business. This article will cover what founders need to know to make the best business decisions during a market downturn and demonstrate how to leverage Pareto to increase efficiency and face the downturn.
What Is a Market Downturn?
A market downturn is a catch-all term to define a consecutive period of time when the stock market continues to decline. This is not the same as a market dip, which describes a temporary drop in prices. A downturn is characterized by a continuous decline, whereas immediately after a dip, the market bounces back.
We can talk about a downturn in only one market (for example, a downturn in real estate), a product (a downturn in hydraulic energy suppliers), or across all stock markets. The current drop experienced in the first half of 2022 affected the stock market globally, with just a few exceptions such as the energy sector.
When the decline is up to 10%, it’s usually dubbed a correction, while sustained market downturns that reach 20% losses are referred to as bear markets. Market downturns can last for months or even more than a year and ultimately can lead to recessions. But not necessarily.
What Is a Stock Market Crash?
A stock market crash, on the other hand, defines a very steep sudden decrease in stock market values. Unlike market downturns or recessions, which happen over the course of several months or even years, a stock market crash happens when the drop in prices is 10% or higher within the span of only a few days.These can be caused by dramatic events, a market bubble burst, or over-speculation. The panic caused by the sudden drop in stock prices also works as a feedback mechanism that exacerbates the crash even further by leading investors to quickly sell their stock at a lower price.
As a consequence, the world economy can be deeply affected, creating great losses for not only businesses but also individuals who invested their life savings. The consequences of a market crash can last for years, or be limited to a specific moment. Let’s see how market crashes have affected the economy throughout the years.
The most well-known market crash in recent history happened in 1929 when the Dow Jones Industrial Average (index of 30 prominent companies in the US) dropped nearly 25%. This induced generalized panic, a race to sell stocks, and the beginning of the Great Depression, impacting the economy for over a decade. In 1987, on what came to be known as Black Monday, market values dropped 22,5% but bounced back within two years. In 2001, after the 9/11 attacks, the market dropped more than 10% but bounced back only one month later.
More recent crashes include the Cryptocurrency Crash of 2018 and the Coronavirus Crash of March 2020. As we can see, market crashes don’t always have a long-term impact and sometimes markets are able to bounce back quickly, especially when generalized panic can be prevented.
What Is the Difference Between a Market Downturn and a Recession?
As we’ve established, a downturn occurs when there is a decrease in the stock market. This doesn’t mean, however, that economic activity is deeply impacted across sectors.
A recession, on the other hand, is an extended period of economic contraction that affects all sectors. During recessions, unemployment rises, gross domestic product (GDP) decreases steeply, and consumer spending tends to shrink.
Long periods of inflation, which lead to decreased consumer spending, can be the trigger that pushes downturns into recession territory. Economists predict that the current downturn has a 47.5% probability of turning into a recession.
What is Causing this Market Downturn?
Markets are constantly interacting with the social, political, and environmental contexts that surround them. Sudden changes in market values may be caused by growing interest rates, political events, wars, natural disasters, or any occurrence that disrupts business-as-usual. Large-scale disruptive events can also cause investors to be more conservative in their investment decisions, which in turn impacts the stock market.
The 2022 downturn is the third significant crisis to be experienced in the tech world since the Dot-com Bubble and the Great Financial Crisis. While we can hardly ever pinpoint the specific event that triggers a crisis, the triple threat of the pandemic, Russia’s war on Ukraine, driving up fuel prices, and policy changes at the Federal Reserve have played a large part.
Between socio-political conflicts and a global health crisis, the perfect conditions for a market downturn were created. Whether this will result in a recession is still unclear.
How Do Market Downturns Affect Startups?
Startups disrupt the status quo of their industries with innovative ways to address their customer pain points, or by creating brand new products and services altogether to address unmet needs.
However, the beginning stages of innovation involve high expenses and usually low revenue. The road to profitability may take startups several years, which is why founders look for external investment streams that support the initial stages of taking the business off the ground and scaling it to profitability.
During an economic downturn, this first stage may come with additional hurdles. There are five main ways in which early-stage startups are affected by market downturns:
- Smaller investment rounds. During periods of economic slowdown or downturn, investors may be less inclined to invest in risky business ventures, which often lead to smaller investment rounds than the historical averages.
- Larger equity requirements. Similarly, due to the decrease in investors available to back up early-stage startups, founders may lose bargaining power and be forced to give up more equity than they had initially anticipated.
- Decrease in company valuations. Early-stage company valuations drop during downturns, also affected by the loss of venture capital.
- Slowdown in customer growth. Depending on the industry, startups may see their customer growth slow down, especially due to the generalized loss of buying power.
- Added pressure to become profitable fast. Businesses don’t generally become profitable overnight. Operating during a downturn creates added pressure to become profitable fast to ensure business continuity and increase the likelihood of getting private funding.
What Happens to Investments During Downturns?
Despite the market contraction, during economic downturns, angel investors and VC investors with riskier profiles will still be willing to bet on high-growth potential startups for the prospect of a high return. However, the amount of investment overall will decrease as a risk management measure.
This is what happened in 2008. As a reaction to the 2008 crisis, private investors backed down from venture investments on a large scale, creating a deficit in investment that lasted from 2008 to 2011.
VC funds and angel investors contain their riskier investments for two main reasons. First of all, investors simply become more risk averse and less willing to invest. Even VC firms, such as Sequoia Capital, New Enterprise Associates, or Index Ventures, who raise large amounts of capital through investors, diminish their investment capacity due to greater caution on the part of their investors. Secondly, VC firms are also cutting costs, which reduces their investment capacity.
Smaller investment rounds mean an added need to control the burn rate, which refers to the speed at which a business is spending its venture capital before becoming profitable. Over the next section, we will look at how startups can survive (or even thrive) through a downturn and secure long-term business continuity.
How Should Startups Face Downturns?
Having explored how startups are negatively impacted, it’s time to look into how founders can face downturns (and come out on the other side). Despite the additional hurdles, we’ll explore how downturns also create new opportunities.
When we look at some of the most successful startups, like Uber, Airbnb, and WhatsApp, we wouldn’t instinctively guess that they were first launched during economic slumps. Recognizing the opportunities that arise in times of crisis can bring new and innovative directions to your business.
Another important internal process to prioritize is reassessing fixed and varied expenses. This is an essential step for successfully navigating a downturn and keeping an extra tight grip on expenditures. Are there any subscription plans that are not being actively used? Are there any marketing campaigns that are not bringing a favorable ROI? This is not about cutting out essential areas, but making sure there are no financial sinks (which is useful even during times of prosperity).
Lastly, besides looking for new opportunities and reassessing expenses, it is critical to focus on team retention. Even if it seems counter-intuitive, hiring new talent that is going to match your desired skillsets and team culture is a financial capital and time sink that can severely hinder your progress. Unless you are dealing with performance issues, focusing on the retention of current team members is the far more cost-effective solution.
After reviewing how founders can minimize hardships during an economic downturn, it’s time for more optimistic figures. Despite the additional hurdles created, many businesses find a way to thrive, not despite the crisis, but because of it. Let’s look at how they made this possible.
Can a Market Downturn Be Beneficial for Startups?
The good news is that innovative, resilient, and adaptable startups often find a way to significantly grow by avidly understanding the market trends and jumping on the opportunities that arise. There are four main reasons why a market downturn may be beneficial for a startup.
- Be the first to find answers to new problems. Freshly founded companies will be in a prime position to innovate alongside the new challenges that arise. Large changes in society create market opportunities to jump on with little or no competition.
- Have less competition. Periods of financial uncertainty are not conducive to entrepreneurship, so it’s less likely that new businesses will face fierce competition.
- Profit from the decrease in prices. The beginning of a business involves high costs to get everything up and running. In periods of economic fragility, many goods and services lower their prices, which can be an advantage to newer businesses who need extra help during the first stages.
- Find talent more easily. The unfortunate rise of unemployment that goes hand in hand with recessions will make it easier for startups to scoop up talented and experienced professionals who can help shape the future of the company.
Resilient businesses remain adaptable and understand the cyclical nature of markets. Despite the additional hurdles that downturns bring about, by keeping the focus on innovation and maintaining flexible systems, new businesses get the best chance of not only surviving but thriving through a market downturn.
After all, startups should not only bring about change and innovation but be prepared to innovate and adapt during change.
Are You Ready to Increase Efficiency With Pareto?
Pareto is here to support growing businesses navigating through these stormy waters. Pareto’s wide range of data operations are designed to support founders in assessing their business, reaching their goals faster, and making the best decisions with strategic data at their fingertips.
The biggest recommendation for new businesses to navigate these turbulent times is to double down on efficiency. By delegating repeatable tasks to the Pareto data experts, new businesses can achieve results faster, while saving time and money in the process. Pareto can also review expenses and categorize financial transactions so that founders can make the best decisions to keep expenses as lean as possible.
Defining the best course of action for a new business requires readily-available strategic quality data. Pareto can help new businesses reach product-market fit faster by helping clients get to know their customers through data enrichment and research, pay close attention to what competitors are doing through market research solutions, and reach new customers through lead generation and outreach.
Whatever your current business priority is, Pareto can assist you in getting there faster and more efficiently!
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