This article is part of GEN's Global Entrepreneurship Week thought leadership series, featuring voices from around the world.
While most of the world slowed down during COVID-19, one part of the economy sped up dramatically. The pandemic and the disruptions it caused greatly accelerated the transition to the digital economy. More than two years later, the result has been a significant inflation in startup valuations. How did we get here and how concerned should we be by this trend?
How COVID-19 Led to Growing Valuations
The first step to understanding the impact of inflation is looking at how it happened. When the pandemic took hold, people around the world jumped to online solutions to keep life going—conducting meetings over video, ordering groceries online, and purchasing connected fitness equipment. Understandably, startups in many digital sectors boomed. Government stimulus to bolster faltering economies boosted demand while production and supply chain capacity were significantly diminished.
After a quick correction in the spring of 2020, tech stock prices rose dramatically and steadily, leading to record numbers of IPOs and acquisitions. Vast amounts of capital flowed to venture and private equity firms, leading to record fundraising and record startup funding. With more money flowing into the startup economy, the number of quality, investable mid-and late-stage startups continued to grow at a very healthy rate of three to four times the rate of normal economic growth (according to Startup Genome data at roughly 10% a year). Still, this was much slower than the supply of capital. Fundraising by VC firms about doubled from2019 to 2021.
Inevitably, all these upward trending lines led to optimism—even hype—and that optimism further spurred a level of inflation in the startup economy that we haven’t seen since 1999. The unavoidable result was inflation in valuations. Investors with ballooning coffers chased a limited number of deals by increasing the size of the checks they offered to founders. As reported in the GSER 2022, late-stage deal and exit valuations almost doubled when assessed in terms of revenue multiples, while the total value of the global startup ecosystem grew 35% per year across 2019–2021, or three and a half times faster than prior years (~10%).
True inflation is hard to quantify for earlier stage deals due to the lack of reliable revenue data, but the fact that the median amount of Series A deals in the US and Europe about doubled from2019 to the first half of 2022 indicates a similar inflation to late-stage deals and exits. The surge in stock market prices has clearly flowed down across the chain, through VCs, and to the whole startup ecosystem.
One notable exception to this story is the growth of early-stage funding in China, which has been significantly slower than in the rest of the world (10%). It’s likely that this is due to restrictive COVID-19 policies that hindered investors from their normal early-stage funding processes. Meanwhile, India was also hit hard by COVID-19 and yet experienced the fastest growth in startup Ecosystem Value of any region in the world during the same period.
Inflation Has Big Upsides for Startups
While the universal law of what goes up must come down rarely applies to tech ecosystems, when it comes to inflation-driven growth, tech ecosystems are not immune. Inflation in valuations has continued into 2022 in some sectors, such as Fintech, but in general we have started to see a correction. Stock markets have declined dramatically. The correction in startup valuations has been more sectorial and surprisingly modest, but it has begun.
Whether they’re worried about the numbers going up or going down, inflation in the startup economy has been met with concern by many. Economists and politicians may hate inflation, but it has a significant upside for founders. Higher valuations mean that entrepreneurs get much more money for selling the same proportion of shares. More capital has flown into tech startups in the last two years than ever before. And more capital means more resources to accelerate growth and develop more powerful solutions. It also encourages more people to take the entrepreneurial route and finally start to work on their big idea. This can only be good for innovation, entrepreneurship, and the long-term potential of the startup economy.
Proceed with Caution, But Be Proactive
Inflation may have upsides for the startup economy, but that doesn’t mean there aren’t pitfalls that founders, investors, and policymakers need to be aware of. Investors are concerned about whether they will be able to achieve their target returns should valuations fall dramatically. This isn’t just worrying for VCs—the health of the startup ecosystem overall is dependent on investors being able to meet their targets and raise their next fund. Their success is important for the future of the startup economy.
For entrepreneurs, the concern is that if valuations go back to historical levels rapidly, this could put them in the difficult situation of having to accept a down round in which their valuation decreases from one funding round to the next. That can have dramatic consequences for both founders and their investors. Startups must pay attention to valuations and modulate their burn rate so that they are not forced to fundraise during a period of significant devaluation.
No one knows when inflation will return to normal levels, but if history is any guide, it will happen eventually. With the stock markets having seen a major correction and many expecting are cession in the near future, valuations may go down very significantly within the next 12months. In this context, entrepreneurs and the whole startup ecosystem must be proactive. Governments should monitor the situation carefully and regularly to see what kind of support may be needed to get startups through a potentially significant correction.
We shy away from the word bubble because it is reminiscent of the late 1990s, when startups got sky-high valuations while having zero revenue. Two decades later, the startup economy is driven by business fundamentals even as early as seed. As such, I'm optimistic that provided experienced entrepreneurs, investors, and advisors tread carefully, the startup economy can weather the current inflationary cycle and come out stronger on the other side.