Fabian Aguilar
Principal
Angel Ventures
/
Expert Contributor

How Early-Stage Startups Provide a Hedge Against Bear Markets

By Fabian Aguilar | Fri, 07/22/2022 - 13:00

Rising interest rates, inflation rates that have not been seen in the last 20 years, market loss rates larger than a polar bear (pun intended) and a tremendous sense of uncertainty that it feels like the entire world could crash anytime. This new “post-COVID” reality (we are technically in the fifth wave in Mexico, but who am I to judge?) has forced us to desperately look for safe assets until the economic cycle enters its positive phase. If you are an investor, perhaps you are shielding yourself against volatile assets by investing in debt funds, government bonds, certain commodities or real estate (and even then, these examples may still be affected by current economic conditions). But there is one asset that, counter-intuitively, may provide a stronger stance against potential losses in the short to medium term (yeah, you guessed it): making a bet on entrepreneurs and their startups during their early stages.

Venture capital is the business of making businesses. As fund managers, we invest in promising entrepreneurs and their innovative ideas by purchasing a piece of the company (equity) at a low price. Then, we help the entrepreneur grow the business during the next five to seven years until we are ready to exit the company at a higher valuation. In a nutshell, we mimic what a public-market trader does: we buy low; we sell high. We are allies to traders, since we invest in companies that later go public through an IPO, increasing the supply of stocks they can trade with. But it then begs the questions: How is venture capital related to public markets? And how can it become a powerful diversification tool? Here are two reasons why VC investments can become a hedge tool during economic downturns.

Financing Costs Have a Stronger Effect on Public Companies

Let’s talk about rising interest rates. An increase in debt cost affects the financial performance of a company, increasing interest paid and, therefore, increasing the burden for a profitable bottom line. It also affects valuation, since risk-premium rates (the extra return that investors theoretically expect from stocks) also increase, driving DCF-valuations down, and together with lower cash-flow projections due to a rise in expenses, the enterprise value of a company will decrease. What happens to early-stage startups then?

A startup (in most cases) will not have debt other than convertible notes from potential investors and some revolving credit facilities from a couple of credit cards (which are not significant during pre-seed and seed rounds). Perhaps a convertible note might be affected by a rise in rates, making it more expensive for the entrepreneur to raise money (and it does), but if you think an investor is using a convertible note to make an interesting profit through its debt mechanism, you are missing the point of doing VC investments. The startup also gains a competitive edge since large corporations will cut costs mainly on capital expenditures and other overhead to compensate for an increase in financing costs. A freshly funded startup will have cash available to capture market share while others are minimizing such efforts.  

Proof of this statement is how much capital startups are raising in each round: Data from PitchBook reveals that late-stage deals have suffered a decrease in the amount of capital they can raise as evidenced in the following table:

 USD millions

Angel

Seed

Early Stage

Late Stage

 

2021

Q1'2022

Change%

2021

Q1'2022

Change%

2021

Q1'2022

Change%

2021

Q1'2022

Change%

Top Quartile

$2.00

$4.29

115%

$4.60

$5.00

8.70%

$20.69

$27.95

35.10%

$51.33

$42.83

-16.56%

Median

$0.54

$0.67

25%

$2.62

$2.54

-2.94%

$10.00

$11.06

10.58%

$15.42

$14.00

-9.19%

Bottom Quartile

$0.17

$0.20

18%

$1.25

$1.00

-20.16%

$2.50

$2.52

0.98%

$4.43

$3.77

-14.91%

Source: Angel Ventures Analysis, PitchBook

 

Early-Stage VC Returns Are Almost Uncorrelated With Public Markets

The key to understanding this concept lies in “time.” Due to its illiquid nature, investors treat each startup as a long-term investment, so speculation and fear-induced sell/buy positions are irrelevant in VC investments, which partially insulate portfolios from the volatility of short-term market conditions. Of course, this statement holds up until the startup becomes a write-off.

Another interesting aspect of a startup’s lengthy investment horizon (if cash burn does not become an issue) is the ability to steal market share in times of budget constraints. Startups have generous cash reserves that can be used to steal market share from slow-moving incumbents and to fight for smaller, less competitive market segments. This swift movement allows them to enhance revenue avenues by increasing economies of scale in marketing efforts. Corporations, conversely, will often grow in a more competitive sector over a large revenue base and the costs of obtaining marginal revenue become way greater than those incurred by an early-stage company.

Finally, startups are forward-looking entities that do not go under the spotlight until the market matures enough to widely adopt a new technology. Startups prepare themselves for many years to become a relevant player in the future when the market finally embraces its technology/business-model/product and becomes mainstream. During that timeline, public markets are unaware of the company’s impact on the market, so it makes little sense to punish its valuation if the company’s fate remains uncertain. If predictions come true and the startup becomes a prime actor in the market, the industry will reward investors regardless of how dire the economic situation was when the startup was founded.   

What Lies Ahead for VC Investments

Many people say that the best time to make money is when a recession happens and the reason is very simple: capitalism behaves like a wave that is always shifting back and forth from positive to negative states. The Great Recession, the Tequila Effect, the Dot-com Bubble and the Global Financial Crisis of 2007-2008 were all short, tumultuous timeframes that were followed by a positive, upward trend that kept on growing until the next crisis started. So, you save yourself some cash, invest it in economic downturns and wait for the market to become bullish again to boost profitability rates.

Venture capital is an excellent supporter of such a strategy: a funded startup will generate vast opportunities for growth and success, while corporations will focus their efforts on remaining financially stable. Of course, economics and people matter in a startup and only the best teams will storm through these dire times. Let us not forget that venture capital is one of the riskiest forms of investment, so a careful approach is always needed. All things considered, VC investors are one of the less risk-averse investors in the financial system, so it is no wonder that their profits are significantly higher compared to other forms of investment; just look at the 20-year returns of the Mexican IPC (11 percent), S&P500 (6 percent) and venture capital (18 percent - Pitchbook database) sectors. In the end, it pays to be greedy when others are fearful.

Photo by:   Fabian Aguilar