Why Everybody Is Wrong About A Market Meltdown

I’ve heard the talk. I imagine you have too.

They say it’s ugly out there in the startup world. But after I break down the fears in the market, I’m going to show you why things will look up this year.

Sure, the evidence is hard to ignore.

Dozens of Unicorns such as Dropbox, NJOY and Blue Bottle Coffee are being marked down. (See this article for more details.)

Last quarter, the average valuation of startups dropped to $28 million from $68 million the quarter before. Even accounting for significant migration of funding to lower-stage rounds, that’s quite a plunge.

More Bad Signs

Fundraises are taking longer than before. (Raising at more reasonable valuations isn’t helping.) IPOs are happening less frequently.

And venture capital investors have been shouting from the rooftops to cut back on growth ambitions, costs and fundraising plans.

Stock market volatility has also dampened pre-IPO investor sentiment. Here’s what Mark Suster of Upfront Ventures has to say…

Frankly, it’s really hard to write checks at later-stage valuations when you know you’ll have to exit into the public markets or sell to a public-market company, and the stocks are declining precipitously. [Note: The Nasdaq has fallen almost 9% since the beginning of the year.]

Founders are getting the message. According to surveys, most expect they’ll have a more difficult time this year persuading investors to back them.

Unicorns have become too expensive for all but a handful of the biggest companies to buy. And they can’t (or won’t) IPO at diminished share prices that would mean major losses for their late-stage investors.

It’s gotten so bad that Unicorns are now derisively being called “Unicorpses.”

A Bursting Bubble?

You already know where this is headed.

Startups and their investors are in trouble. The good times are over. It’s what everybody is saying. So it has to be right.

Except I’m not buying it.

There is no crisis. No bubble bursting.

What we’re witnessing is a limited and healthy correction. A market made up of hundreds of sellers (the startups) and buyers (the VCs) is doing exactly what it’s supposed to.

It’s self-correcting, lowering valuations that had gone up too high too fast.

Granted, the contraction isn’t over.

In a recent survey done by Upfront Ventures, over 90% of VC investors expected valuations to go down this year. A third expected “significant price corrections.”

Sentiment has clearly turned bearish. Then again, sentiment is often a lagging indicator.

It certainly is in this case.

Amid the calls for caution and restraint, the startup market is quietly gearing up for a resurgence.

I expect valuations to start climbing again before the year is out.

Basic Market Dynamics at Work

So, what do I see that others are missing?

A shift in supply and demand.

While the demand for capital will stay steady or perhaps grow slightly, the supply of capital will surge because…

• There is more than $1.4 trillion of cash reserves among the S&P 500 companies.

• The tech “Big Five” of Google (GOOGL), Apple (AAPL), Amazon (AMZN), Facebook (FB) and Microsoft (MSFT) are sitting on hundreds of billions of cash.

• Increasing amounts of Chinese money are flowing into these young companies.

• Sovereign wealth funds, foundations, hedge funds and mutual funds won’t stop pouring money into the private market. It’s one of the few places where they can still find real growth. At lower prices, it’s a no-brainer.

• And everyday investors will be ramping up their capital contributions with Title III and Regulation A+ coming into effect.

A New Trend

Of course, not all the cash companies have amassed will go into startups.

This is the X factor… So let’s look at the numbers.

Around $70 billion of VC capital is invested into startups every year.

If just a fraction of the hundreds of billions of corporate cash goes toward startups, it would still inject a substantial amount of capital into startups.

The result? Valuations again on the rise.

But can we really expect S&P 500 companies to loosen their purse strings?

One Underrated Source of Capital

I think so, thanks in part to an underrated source of capital.

I’m talking about industrial companies. They’re being disrupted.

Some of them are facing challenges that rise to the level of existential threats. Companies from printed media, the taxi industry, auto manufacturers, brick-and-mortar stores and record label companies form a short list.

Not surprisingly, the CEOs of these old guard companies are having trouble warding off these attacks. (I strongly recommend you read The Innovator’s Dilemma to understand the dynamics behind this.)

I expect the legacy companies will increasingly adopt the “If you can’t fight ’em, join ’em” strategy. They have no choice.

It’s already underway. Car manufacturers establishing operations in Silicon Valley. GE and other industrial companies setting up investment funds targeting startups. Industrial giants and mega-retailers investing or buying out companies.

For example, Monsanto has bought its digital expertise via acquisitions. So has Under Armour (UA). GM (GM) has put $500 million into Lyft. Ford (F) is working with Amazon and reportedly Google.

It’s hard to envision S&P companies NOT taking advantage of the one asset they have plenty of and startups have so little of…

Money.

Nor is venture capital investment drying up.

According to Upfront Ventures’ survey of 73 investment firms, 82% said they expected to keep the same pace of investing in VC firms. Eight percent suggested they would increase investments.

The so-called “smart money” certainly isn’t retreating from startups. When you add on top of that money from China and corporate cash, that’s a lot of greenbacks backstopping startup investment opportunities.

Don’t get me wrong. The correction is real. And valuations will continue to adjust.

But you shouldn’t take all the stupid talk about meltdowns and crashes seriously. The free play of market forces is working.

My prediction: The startup space will recover far sooner than most people expect.

And a new cycle of robust growth will begin.