Waiting for fundamentals and reason to return to startup investing has been like waiting for daybreak – anticipation of the inevitable awakening. Fortunately, we didn’t have to wait too long for the current market frenzy to subside.

We’ve been here before…?

It’s only been 7 years since the end of the Great Recession and 13 years since the carnage of the dot-com bust. Despite the short timing, investors seem to have forgotten the lessons from prior downturns.

Anytime technology startups are likened to mythical creatures – thus the aptly named Unicorns; privately held startups with ZERO dollars in profits, but implied valuations of $1+ billion – that should serve as a wake-up call for sophisticated investors/advisors of an impending bubble:

An economic bubble exists whenever the price of an asset that may be freely exchanged in a well-established market first soars then plummets over a sustained period of time at rates that are decoupled from the rate of growth of the income that might reasonably be expected to be realized from owning or holding the asset.

Watching the Unicorn proliferation felt like reading a textbook.  Hopefully, the coming market correction won’t be as bad at the dot-com bust.

Dot-Com Era Revisited

In the early 2000s, the initial public offering (IPO) market was the “well-established market” that foolishly priced immature companies at astronomical levels. The dot-com startups’ growth prospects did not justify the valuation forward multiples, causing a severe market pullback.

Once investor funding dried up, dot-com management teams sealed their own fate by spending irresponsibly and prioritizing growth over profits. The rest is history.

Does any of this sound familiar?

Despite the striking similarities between the dot-com and tech startup eras, some people are questioning the current slowdown in VC investment.

So what happened in Q1 2016?

Well, I believe the first rays of enlightenment are starting to illuminate the landscape.  I am hopeful that this wake-up call is a return to reason.

Depending on which venture capital authority you trust, the market seems to be signaling that something is afoot. According to Thomson Reuters, Q1 2016 was the strongest quarter for VC dollars raised since 2006!

•  U.S. venture capital (VC) firms raised $12 billion during Q1 2016
• a 59% increase in dollar commitments over the same period in 2015

Now despite healthy coffers, VC investment in startups during the same period was mostly flat.  So why the disconnect?

Perhaps it’s due to the realization among investors, academics and journalists that Unicorn valuations and growth prospects are unreasonable.  Only time will tell.

Here’s the good news.  Unlike prior bubbles, Unicorns are still privately held, so VC firms and institutional investors will bear the brunt of falling valuations.  Yes, startups will suffer more closures, layoffs and belt-tightening, but the fallout will mostly be contained.

Reason vs. Unicorn Fantasies

The return to reason has already begun.  Since Q4 2015, we’ve seen signals of investor caution.  The decrease in the number of Unicorns, the down rounds and the well-publicized write-downs offer additional clues.  I am encouraged by my recent retail/consumer angel investor due diligence meetings, where the focus has shifted to questions around profitability, business model and sustainability.

In hindsight, it makes perfect sense that investors took a less analytical approach when evaluating pioneers like Facebook, Google or Amazon.  However, let’s not confuse ourselves, or be convinced by the founders of the tenth “me too” startup that their primary focus should be on growth, not profits.

Yes, now that dollars and sense are a guiding force, I’m excited to meet the last startups standing.  The winners will be startups with viable business models and loyal paying consumers.  The losers will be startups with limited addressable markets and no path to profitability.

Much like the NCAA during March Madness, what is emerging is a new breed of Cinderella startups.  Founding teams that glorify grit and avoid chasing fads and vanity metrics will come out on top.

A New Day Dawns

Of course, plenty of transformational opportunities remain.  We are still just scratching the surface in the consumer industry on artificial intelligence; virtual reality; big data; and leveraging the power of technology to automate retail.  Evaluating investments in the aforementioned sectors will take time and will likely breed a new class of Unicorns who blaze a path.

For the vast majority of tech startups in more mature sectors, nightfall lasted too long.

I’m looking forward to being a conduit for those deserving entrepreneurs with good ideas, amazing work ethic and the humility to learn from mistakes. Likewise, I’m relieved to see an end to the entitled mindsets looking for a quick exit.

Thank goodness that no matter what happens in the dark of night, dawn always comes in the morning.

@LockieAndrews is the CEO and Founder of Catalyst Consulting www.catalystconsult.com, a boutique consulting firm to retail and consumer brands, digital and technology firms, and venture capital and private equity firms.  With 20+ years of general management experience, Lockie has assisted high growth companies (e.g. Nike, Lane Bryant, Limited Stores, Concrete Platform) in diverse areas such as strategy, innovation, revenue enhancement, operational/financial improvement and fundraising.  Lockie is also a sector lead for the HBS Alumni Angels of NYC.  She will be moderating the “Beyond Venture Capital Investment” panel at @ShopTalk in Las Vegas in May 2016.

 

Sources: Dealogic, Wikipedia, CB Insights, Thomson Reuters