For my friends not in the VC space, I wanted to share some learnings about what’s been happening in the market over the last year and how this is related to all these layoffs you see in the news and on LinkedIn.
But first some context. In 2008 coming off a financial crisis of global proportions, the US started something called Quantitative Easing (QE), creating almost $13T (with a T!) of new money over the last 14 years. The idea is that this would help stimulate the economy.
The way QE works is that the central bank buys assets (bonds usually) from its member banks, and that in turn drives down the cost of borrowing and should incentivise banks to loan out more cash. What usually ends up happening instead is that banks dump this cash into the market, and it inflates every asset from bonds, to stock, to real estate. You could argue that this is one of the drivers for the growth of alternative investments like Crypto, as investors were looking for new, less saturated markets to invest in.
At first, on a global level, we didn’t see any meaningful inflation in consumer markets, and since I’m not an economist I won’t attempt to explain why, but I’ve heard that the economy was either deflationary at the time, or that banks had to keep more cash in reserve to shore up their balance sheets, or my personal favourite, that the US dollar is a global reserve currency, and the inflation gets absorbed globally instead of in just the US.
Fast forward to COVID 2020/2021, and instead of a demand-side shock as we usually have in a financial crisis, we got hit by a supply-side shock with supply chain issues, and people getting sick and not being able to work. Combine this with a $5.2T (with a T!) of relief aid being approved just in the US, you’re looking at an inflation crisis waiting to happen.
At the start of this year (2022), with the economy recovering and inflation getting out of control, we saw the US central bank slam the breaks on Quantitative Easing (14 years of it!), and massively increase interest rates. Higher interest rates are like a break on economic growth by making borrowing much more expensive, but you don’t want the treatment (raising interest rates too high), accidentally killing the patient (the economy).
The end effect is that company valuations (and indeed most investable assets), are suddenly way less valuable today. You can think of these as terminal values having more aggressive discount rates, or in human terms, less money competing for risky assets.
In the VC space, this hit some markets hard (fintech valuations down almost 80% in some areas; other SaaS businesses down 50-60%). Both in the competition for risky assets sense, and in the falling valuations of public companies that are used as comparables for exit calculations. This isn’t necessarily a bad thing, as valuations are reverting back to more normal levels.
Ultimately, this means that investors are more conservative — fewer pre-emptive rounds (ie. funding before traction justifies it), and a demand for better capital efficiency (less money can be used for growth). Tech companies then need to adapt quickly to right-size their hiring, requiring a 20-30% correction in staff to ensure sufficient runway to catch up to their new valuations, and that’s why you’re seeing every tech company cut on hiring across the board. Combine this with what looks like a traditional recession, non-tech companies will also likely be more conservative.
Clear as mud? To leave this on an optimistic note, it’s a better time than ever to invest in Venture Capital or build new businesses. I know I’m not an economist, so take this as an observation of the last 14 years.
Would love to hear your thoughts.