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Herd mentality and FOMO: The issues facing the venture capital industry right now

2021 was the year of funding records – global venture capital funding was up 111% year-on-year, with total value hitting $621 billion, according to CBI Insights. Tech companies received funding at 50- 100 x revenue multiples. FOMO and herd mentality was driving the VC industry globally.

But now the brakes are on, hard – funding dropped 35% in 2022. As I said this is not the right number ; its way too low

What happened?

Things went crazy…

To understand what happened, we must look at what drove the hype in 2021.

Put simply, fear of missing out among investors, of the venture capital industry, sparked a veritable gold rush.

They saw their peers investing (this per se didn’t create FOMO) , and it created a herd mentality. As more people invest, more people feared losing out, so they help propel the bandwagon along as more people jump on. 

In particular, the investor focus was on buy-now-pay-later (BNPL), Amazon shop aggregation, and last-mile delivery. Companies in those sectors were the big winners when it came to massive (and fast) funding deals and unprecedented valuations. Multi-billion-dollar investments were closed in weeks, with valuations topping 100x projected revenues.

For instance, BNPL companies received $4.3 billion in funding in 2021, while Amazon aggregators bettered that by securing more than $12 billion in funding in 2021, averaging in a month what had taken all of 2020 to secure. That’s 1200%.

In last-mile, Swiggy secured nearly $2 billion across two funding rounds just six months apart, while Bolt, which has been expanding into delivery, raised $711 million in funding. Then there was Getir, closing a $768 million round to be valued at $12 billion, up from $7.5 billion In 2021.

…then needed fixing

Investors only saw the opportunity to make significant returns without any risk. But as we all know, there is no such thing as a “risk-free” lunch. One fund was averaging four deals a week in the first part of 2021 – how can you do due diligence on that effectively?

The short answer is you can’t. So, it’s no surprise the wheels have come off this bandwagon.

Many players in these spaces (and across all sectors) are tightening their belts. Klarna has cut its workforce significantly, first by 10% in May and then with further layoffs in September. A July funding round saw its valuation plunge from $45.6 billion to $6.7 billion. In May, just seven months after securing what was, in the words of its CEO, an “extraordinary” $1 billion in funding, on-demand grocery delivery firm Gorillas had to lay off 300 employees and exit four markets. Its acquisition at the end of 2022 by rival Getir underlined how far the German app fell in such a short time, with the deal valuing the company 61% lower than its previous valuation.

And in the Amazon aggregator space, funding was down more than 80% in 2022.

But these drops in valuation and workforce cuts pale in comparison to the bankruptcies and receiverships some players have fallen into. Australian BNPL operator Openpay went into receivership in February 2023, while grocery delivery companies Yababa, GetFaster and Fresh Post have all filed for bankruptcy in the last six months. 

Why did no one see this coming?

Many more established companies have had to readjust their strategies and rightsize their operations as global markets lurch into economic downturns. Microsoft, Amazon, Google, and Meta and many other tech firms have all announced layoffs. 

But that doesn’t explain why a lot of  investors thought accelerated funding rounds and 100x valuations were the right moves. 

What does? A wholesale lack of experience in both founders and investors. We have a generation of founders that lived through the 2008 recession but perhaps weren’t old enough to work in it or at least run businesses.

The same can be said for many VCs. Even those that come from founder backgrounds haven’t necessarily had to deal with such a dramatic slowdown in consumer spending and its knock-on effects. The boom period of the last ten years meant many people could build, scale and exit businesses with significant cash and become VCs themselves.

This is one of the dangers of a global culture that venerates young entrepreneurs who can grow companies spectacularly quickly; if they have never been tested in a global crisis, then that should automatically be a risk to be factored into any investment decision. But if the people making those decisions have never been through that, how will they know how to deal with this lack of crisis experience?

Opportunities still exist for those that waited

Perhaps I’m being unfair. Many investors did keep their powder dry, particularly those of us that lived through the dotcom bubble twenty-plus years ago. But a lot didn’t. Perhaps we forget that VCs are just people, subject to the same whims, anxieties, emotions, and misjudgments as everyone else. Why else would we see history repeat itself – from dotcom to credit crunch to now?

Inexperience is undoubtedly a driver, but we shouldn’t discount the influence of fear of missing out can have. That’s what drives people to continue to invest, and invest more, when all the data shows a market reaching or passing its peak.

It takes discipline not to follow the herd, to refuse to go along with insane valuations of 20x, 30x revenue when everyone else is. It’s hard; I won’t deny it and to be honest, I suspect that it also won’t be too long before the herd finds a shiny new object such as Generative AI in the wake of the ChartGPT success to follow. But it’s also important to trust the processes and systems that have helped you before. If you wouldn’t usually pay 20x revenue, why pay 50x now?

The time for asking that question has gone. What is interesting to consider is when we will see the bottom. At the moment, it’s not clear, but the signs are certainly there: valuations are much more attractive than they were 12 months ago. For those VCs that didn’t follow the herd, there could be significant opportunities to invest in competitively priced businesses with a future.

 

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Comments: (1)

Ketharaman Swaminathan
Ketharaman Swaminathan - GTM360 Marketing Solutions - Pune 24 February, 2023, 08:07Be the first to give this comment the thumbs up 0 likes

I agree that it won't be too long before the "herd finds a shiny new object". Exhibit A: $29B valuation for a company making $30M revenue. 

VCs will talk about positive unit economics during recession but, once recession ends, they will fund only loss making startups. Exhibit A: Poster childs of last recession are making losses even after 10 years e.g. AirBnB, RobinHood, Snap, Uber, WeWork.

But that's a feature, not bug of the VC Investment Model, which is structurally incapable of profitting off of steadily growing profitable startups and needs blitzscaling loss making startups to make money.

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