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Bear markets good for startup investors

Angel investing makes sense in good times and in bad times for all different reasons. Investing in startups is not for the faint hearted even in the best of times. But in fact it makes financial sense in the best and worst of economic times.

Being an angel or early stage venture investor also makes sense on a raft of other fronts too.

New companies produce almost all our net new job growth. Startups are building businesses to solve some of the world’s big problems like climate change, feeding the world, curing disease and social equity. And kiwi startups in particular are showcasing Aotearoa’s ability to build outsized value grounded in empathy for people and the planet.

But let’s return to why it makes financial sense to invest in startups in bull and bear markets.

A well selected portfolio of startups – one that includes at least 15-20 ventures that have all been subject to an appropriate level of due diligence, including to make sure it’s being run by a high quality team and that they are going after a massively valuable market – will generate an internal rate of return of circa 25-35%.

All the signs are that we are coming to the end of one of the longest bull runs in history. In bull runs startups and their investors benefit from easier access to capital and there are more liquidity options as bull markets are more conducive to the acquisitions and IPOs which realise the returns of startup investment.

In bear markets, only the best startups survive. These are startups grounded in genuine value, and tend not to be those validated purely on their momentum. “Momentum based” investment tends to rely on growth for growth’s sake which is often needed to justify unrealistic valuations which have been hyped up to deliver outsized financial returns which are ungrounded in intrinsic value – think WeWork. Valuations in bear markets tend to be lower. They are grounded more realistically in actual value. Lower more realistic valuations provide a more rewarding upside for investors and founders when the cycle swings back. Bear markets also tend to mean access to talent is cheaper.

I attended the USA Angel Capital Association conference a month or so ago. Ron Weissman from San Francisco’s Band of Angels did some crystal ball gazing. He noted we are coming to the end of a 10 year party observing that share prices have fallen dramatically in recent months and noting that public company M&As are already down by a third. He suggested that the IPO window is nearly closed, with 50 SPACs currently underwater and Tiger Global, a voracious VC investor, has lost two thirds of its nearly $25bn gain in recent months.

Ron set out some lessons from the recent recessions. Late stage companies tend to suffer most in down turns. Angel backed startups, on the other hand, suffer the least impact. He did caveat this by noting this won’t be the case if there is a series A crunch, but with $300bn in VC ‘dry powder’ this risk is low. Market declines are great times to build companies. We should not think short term. Startup companies need up to eight years to mature. Early stage investors and startups should have a clear line of sight to three or four times the follow-on capital for every early stage dollar they invest.

AANZ, NZ Growth Capital Partners and PWC recently released the data which provides a snapshot of Aotearoa’s 2021 early stage venture market. Mirroring other capital markets around the world, this revealed our highest ever uplift in investment in both deal and dollar terms – we recorded 172 deals (compared to 100-130 for the last five years) and $254m of investment (up 60% on the previous year and twice the size of any other percentage uplift in investment since we started collecting data in 2006).

This scale of uplift year on year, even in a bull market, is not sustainable for a number of reasons including the rate at which Aotearoa can produce quality startups and the depth of our capital markets.

That said, it’s taken us 15 years to invest $1bn in NZ startups. The Angel Assn and others in our ecosystem, such as Global Entrepreneurship Network NZ and the newly established Startup Advisory Council, have huge ambition to substantially lift the quality and quantity of startups. Angel Assn NZ hopes to maintain at least $250m of investment per annum in startups for the next 5 years to invest the next $1bn in the next 5 years, not 15 years.

If we are to deliver the impact we know startups can have on Aotearoa’s future we all have a role in making sure this happens.