I don’t know exactly when the stock market’s marathon bull market will end. But the end is getting close.
Investing in a flat or falling stock market during a recession isn’t easy.
Early-stage investing provides a nice shelter from the recession. Startups that you invest in now will be going public long after the recession has ended and the stock market has rebounded.
But even though investing in startups provides a nice shelter during recessionary times, early investors still need to adjust to changing economic realities. And so do the startups they’re considering investing in.
Here are three adjustments that should head your list…
There’s plenty of money to go around right now. But that won’t always be the case. In a recession, banks become more discriminating, as do venture capital firms. The cost of borrowing goes up. Customers have less money to spend. Achieving hypergrowth becomes more challenging as spending growth either slows or reverses.
In general, I refuse to seriously consider startups that spend excessive amounts of money. Nowadays, this rule has moved to the top of my list. It’s more important than ever that startups fortify and nurture their cash holdings. You should look for startups that…
- Have enough cash to last through the recession. Usually, an early-stage company raises just enough funds for a year… perhaps 18 months at the most. That’s because founders are justifiably reluctant to sell equity. But companies now need to shift their priorities and raise enough cash to last at least two years. That shouldn’t be too difficult for deserving startups. And there’s no better time than right now to do this. Venture capital is still flooding into the startup space. And money from crowdfunding continues to increase.
- Have a business model that does not require huge spending to grow efficiently. Look for software as a service companies or ones that don’t depend on a big budget to finance their marketing efforts. Bootstrapping companies are always welcome. Also look for companies whose net burn is low.
- Don’t have significant debt or high-cost initiatives. Big-budget projects can wait. If they can’t, that’s a problem.
While revenue growth remains part of the equation, you should look beyond growth and be especially wary of companies following a “growth at all costs” strategy. Only companies with the strongest fundamentals will get through a tough recession. Look for big margins, low customer acquisition costs (especially compared with lifetime value), sticky customer products and high customer satisfaction ratings. Place more emphasis on smart growth and less emphasis on hypergrowth.
Startups whose products are cheaper than legacy companies should do well in a recession. A recession might actually boost their growth. And because renting is cheaper than owning, companies that operate in the sharing economy should also do well.
Startups that prioritize convenience over price are particularly vulnerable. The same is true for startups that prioritize sustainability or the environment over price.
These are tough calls for investors who want their startups to make a positive impact on the world. They should gravitate toward sectors like healthcare, where cures and new treatments will always find a market. So will technology that improves how healthcare is provided.
Startup Equity’s Superpower
If you keep these simple rules in mind, you should do very well investing in startups… even in recessionary times. Private startups and public companies operate in parallel but separate universes. They exert little influence over each other. In fact, the startup space has shown negligible correlation to public stock markets. So when the public stock markets fall, it shouldn’t drag down the collective price of startups with it.
Crowdfunding makes investing in startups even more affordable. It can take as little as $50 or $100 to invest in a quality startup.
I’m not advocating replacing your entire public company investment portfolio with startups. But high-upside private equity has a place in any portfolio. In a declining stock market where a recession reigns, it makes even more sense to invest in the one equity class NOT falling and whose upside remains intact.