Market history says a recession could produce the next Airbnb or Slack

Layoffs, rising interest rates, spiraling valuations — this is a tough time for startups.

Amid the broader economic downturn and bear market in tech stocks, investors have been favoring profitability — or at least a reasonable path to get there — over the promise of future growth.

That’s been a tough sell for the VC-funded startup market’s ability to monetize innovation, at least in the short term.

According to the just-released annual review of venture fund trends from PitchBook and the National Venture Capital Association, one of the biggest takeaways in 2022 was the “lethargic” pace of exits. A total of $71.4 billion was generated in exit value, a 90.5% decline from 2021’s record of $753.2 billion. It was the first time exit value fell below $100 billion since 2016, with late-stage companies the hardest hit. Public offerings of VC-backed companies fell to a level not seen since the early 1990s, with just 14 public listings in the fourth quarter.

We’ve been here before.

As the economy melted down in 2008, legendary venture firm Sequoia published the infamous memo titled, “R.I.P. Good Times,” proclaiming to startups that “cuts are a must” along with the “need to become cash flow positive.”

More than a decade later, those that heeded this advice went on to become game-changing tech behemoths, including CNBC Disruptor 50 companies Block, Pinterest, Slack, Twilio, and Cloudera.

One in particular went on to reach a market cap of more than $50 billion, despite going public in a volatile environment: Airbnb, an eight-time Disruptor 50 company that shares the same distinction with just one other company in the annual list’s history — Stripe.

Stripe topped 2020’s Disruptor 50 list released shortly after the Covid crash. Months before, Sequoia published another widely read memo titled “Black Swan,” which pointed to sustained inflation and geopolitical conflicts that would limit the ability for “quick-fix” policy solutions like slashing interest rates or quantitative easing.

Last year, Sequoia partners admitted they underestimated the monetary and fiscal policy response to the Covid crisis. Two months later, we got an idea of the market correction they were signaling when Stripe cut its internal valuation by 28%, from $95 billion to $74 billion, which was one of many private company haircuts seen in 2022. This week, it was reported by The Information that Stripe has cut its valuation again, by 11% to $63 billion.

Founded in 2010, Stripe’s business took hold as the U.S. economy and labor market began to recover from the financial crisis and was turbocharged during Covid. “We were much too optimistic about the internet economy’s near-term growth in 2022 and 2023 and underestimated both the likelihood and impact of a broader slowdown,” its founders wrote in a recent layoffs memo.

“The world is now shifting again. We are facing stubborn inflation, energy shocks, higher interest rates, reduced investment budgets, and sparser startup funding. … We think that 2022 represents the beginning of a different economic climate. … Today, that means building differently for leaner times,” the founders told employees.

“Investors continue to invest in innovation at times like this,” said Kyle Stanford, senior analyst at PitchBook. But he added that it’s most apparent in the difference between the seed and late-stage venture growth.

Seed rounds had a record deal value in 2022, and valuations continued to grow even as late-stage venture growth near to the public market suffered. Meanwhile, with revenue multiples as high as 150x in 2021 and now down to as low as 10x in publicly traded peers, investors look at companies close to the public markets as being in a “can’t pay those valuations” penalty box because the investors “won’t get it on exit in the next year or so,” Stanford said. 

That huge gap remains today for many of those companies, especially with so many of the opportunistic investors who poured into those companies – crossover funds, private equity funds and sovereign wealth funds – pulling back since they can’t get the quick exit profits at high multiples that were abundant in 2021.

Financial crisis as innovation catalyst

Despite the environment and lack of public deals, VC funding remains strong. Venture funds raised a record amount of money in 2022, with $162.8 billion closed across 769 funds, according to PitchBook and the NVCA. It was the second consecutive year over $150 billion. And younger companies are getting more of the money. In 2022, early-stage VC deals raised $68.4 billion, nearing the 2021 figure, albeit with the first half of the year responsible for over 60% of the money. Meanwhile, investors ran from late-stage VC deals, with fourth quarter deal value of $13.5 billion at the lowest level in five years.

Previous recessions have ultimately produced dominant tech companies, including iconic names like Hewlett Packard, Microsoft and Electronic Arts. During the 2008-2009 downturn, specifically, tech unicorns were created at a total value of $150 billion, according to Startup Genome, including 24 Disruptor 50 companies. Airbnb, Block, Pinterest, Slack and WhatsApp, among them.

It won’t get any easier for the biggest venture-backed firms in the short-term.

“Late-stage venture is in a difficult spot,” Stanford said. “But going public in a down round won’t end these companies. We’ve seen companies struggle as public companies and then skyrocket, so a lower value-IPO is not the end of the road.”

But where investors are really looking within the roughly 3,600 funds closed in U.S. in the past four years is among the many funds (about 1,650 of them) under $50 million that are focused on making deals in seed and pre-seed companies. “There is lots of capital for new ideas and emerging tech,” Stanford said.

Tougher times also mean better pitches from founders and better-run companies. Creating a company during a downturn implies a business plan for more sustainable growth, and startups today will need to bring much more detailed and perfected pitches to investors. “They need to be at their best to get capital now,” Stanford said. “But when can generate new market share in a difficult market, when the market does turn, they are in a perfect position to capture more market share and customers.”

Whatever Airbnb and Uber became during the decade of frothy valuations and “growth at all costs” startup business models, they started by being scrappy companies in difficult times seizing on ideas that were disruptive.

“Investors should pay special attention to the companies that emerge from this downturn,” said Julia Boorstin, CNBC’s Senior Media & Technology Correspondent and creator of the Disruptor 50, in an appearance on CNBC’s “Squawk Box” earlier this week. “The leanest of times can force new kinds of scrappy innovation,” Boorstin said.