Startups: The Door Is Closing

European Straits #239

Apologies for my absence, as I've been occupied for nearly two years with entirely distinct pursuits—tracking down wrongdoers across borders. This journey is ongoing, yet during this period, I've gained a clearer perspective on why and how I intend to rejuvenate this newsletter.

To kick off, I delve into the seismic transformation that I believe we are presently undergoing. In short, I believe the era of startups has reached its culmination, and entrepreneurs who have yet to secure strong market positions should begin exploring a wholly different playbook.

1/ The inspiration for this newsletter came from viewing one of those impromptu videos featuring the geopolitical strategist Peter Zeihan as he wanders in the great American outdoors. I was particularly drawn to this one because it focuses on innovation, a subject that Zeihan acknowledges doesn't typically hold a prominent place in his thinking. Here’s the relevant quote (emphasis mine):

Innovation requires a fairly specific set of circumstances. You need enough people in their 20s and 30s imagining a future and developing the tech, along with a capital-rich environment.... Our world is changing, and these conditions are no longer present, so we must temper our expectations. Anything that hasn't reached operationalization...probably won't make it.

Zeihan proceeds to talk about six specific technologies, spanning from the one that's most probable to remain confined to the lab, to the one with the highest likelihood of successfully going down the path to widespread adoption. Listed in ascending order of transformative potential, we have: small modular nuclear reactors, artificial intelligence, increased outer space satellite deployment, personalized medication, shale oil and gas, and agricultural gene editing.

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2/ Zeihan does have his share of critics and skeptical followers—myself occasionally included. However, his insights on innovation strongly strike a chord with me, as my perspective on innovation has been molded by the wisdom of two formidable thinkers:

• Veteran venture capitalist Bill Janeway, who in his seminal Doing Capitalism in the Innovation Economy emphasizes that “At any point in time, there is more technology available than anyone knows what to do with.” This underscores the existence of countless groundbreaking technologies that never manage to reach the market.

• Economist Carlota Perez, who in her foundational Technological Revolutions and Financial Capital illustrates that all technology-driven “great surges of development” are made possible by investors relinquishing rationality and igniting speculative bubbles that ultimately lead to widespread financial losses. This aligns with Zeihan's perspective on the importance of abundant capital for translating cutting-edge technology into widely adopted innovative products.

These two ideas synergize flawlessly, capturing Zeihan's assertion that the door to innovation having a transformative impact is slowly shutting. The current cohort of tech entrepreneurs must act swiftly before they grab the metaphorical Indiana Jones hat of Zeihan’s “operationalization” and establish their foothold in the market. Once the door firmly closes, an entirely new landscape will unfold. Entrepreneurs will need to embrace an entirely different playbook, and the tech startup (as cultivated and fortified in post-dotcom bubble Silicon Valley) might fade into obscurity.

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3/ Let's delve further into the underlying causes. According to Zeihan, one factor contributing to the decline of innovation is shifting demographics: the population of individuals in their 20s and 30s is steadily diminishing, and he deems this specific age group essential for fostering innovation.

Intriguingly, this notion seems to resonate with Paul Graham's perspective that to cultivate Silicon Valley-style startups, a critical mass of nerds needs to be present, often congregating around universities—which, by coincidence, predominantly attract people in their 20s and 30s. Notably, Graham doesn't dismiss the potential for older individuals to drive innovation, yet his emphasis on the significance of universities implies that generating a concentrated hub of nerds becomes challenging if they're beyond the typical university age range.

In any case, the discussion on the economic impact of shifting demographics is crucial and I’ll make sure to revisit it in upcoming issues.

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4/ Another underlying cause of innovation slowing down is the growing capital scarcity. Since the 1990s, there have always been persistent justifications for keeping interest rates low or even extremely low. During the Alan Greenspan era in the 1990s, deflationary forces driven by globalization removed the need for central banks to combat inflation. Subsequent actions aimed to mitigate the aftermath of the dotcom crash, followed by analogous measures in response to 9/11, the 2008 financial crisis, and most recently, the global pandemic.

A quick look at the chart below offers a glimpse into the prolonged period of low/extremely low interest rates since the onset of the dotcom bubble in the 1990s:

Source: Board of Governors of the Federal Reserve System (US). fred.stlouisfed.org

I intend to delve further into the connection between interest rates and innovation. However, it's sufficient to outline the following sequence: elevated interest rates align with diminished returns in the public equities market, subsequently impacting venture capital returns which are closely tied to public equities market performance.

Consequently, with the ascent of interest rates, VC firms encounter a challenging situation. Elevated expectations for returns arise due to the attractiveness of other asset classes with higher interest rates. Simultaneously, investors observe the subdued VC returns and understandably exhibit caution when it's time to allocate additional capital to VC funds. It's no surprise that the VC industry is grappling with a crisis, as managers find it tough to raise new funds, and firms are progressively implementing layoffs. Hence the reduced availability of capital for innovation.

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5/ There’s another factor: deglobalization, which is also a favorite topic of Zeihan's. It significantly contributes to the dwindling prospects of innovation in various ways.

First, a less globalized economy necessitates reliance on resources within a reasonable proximity. Raising foreign capital, recruiting international talent, and accessing distant supply chains will become progressively challenging. Being compelled to draw from a more limited pool of essential resources inevitably obstructs entrepreneurs from acquiring the required inputs for innovation.

Second, deglobalization will substantially increase the challenges businesses face when attempting to expand across international borders. Admittedly, for numerous startups, the signs have been evident for a long time: numerous entrepreneurs in Europe, although successful within their domestic markets, have struggled to penetrate foreign markets, ultimately settling for less ambitious goals.

This outcome diminishes the potential for significant scale-related returns, primarily due to the relatively modest size of most European markets. In contrast to the aspirations prevalent in the tech realm even as recently as 2015, the global landscape, especially in Europe, remains inherently divided. This fragmentation undermines startups' access to the returns essential for ensuring the sustainability of innovation. The consequence is a reduction in innovation.

Thirdly, a world characterized by greater fragmentation inevitably sees governments taking the lead over the corporate sector. While there are instances of innovation-driven industrial policies emerging from such a shift, subsequently fostering the ascent of future global leaders, the norm is that formidable governments fortified by substantial commercial, cultural, and geopolitical boundaries tend to hinder innovation. The resurgence of Friedrich List's “National System of Political Economy” will inevitably result in numerous losers, with only a select few emerging as winners.

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6/ I believe that the aforementioned factors favor larger organizations over startups. In essence, we are on the verge of witnessing the resurgence of Tyler Cowen’s “anti-hero”, namely Big Business—while simultaneously observing the waning influence of the iconic image of tech entrepreneurs crafting innovative marvels in their garages.

This transition has been unfolding over a considerable period. Most industries are now under the dominion of old, established players who, after being momentarily caught off guard by Silicon Valley-style new entrants, have learned enough about the new techno-economic paradigm to reach an equilibrium, level the playing field, and subsequently regain the upper hand. Consider examples like Disney responding to Netflix, the taxi industry countering Uber, major music labels dictating terms to Spotify, hotels striking back at Airbnb, traditional banks facing off against neobanks, and even Walmart vying with Amazon. I can't identify many sectors, aside from perhaps advertising, where newcomers have decisively triumphed over incumbents.

And understandably so, considering we now inhabit Zeihan's world—one that’s less friendly to innovation. The scarcity of capital plays into the hands of established corporations: only larger entities can tap into capital markets and secure loans from banks during periods of high interest rates. The shift in demographics also favors incumbents, as they are better equipped to provide attractive conditions to the ever scarcer pool of young talent—the very group from which innovators often emerge. Finally, the resurgence of industrial policy at a national level offers significant advantages to established players, enabling them to exert influence through effective lobbying efforts. When governments possess renewed authority to shape the destiny of companies and markets, it's primarily the larger incumbents who can successfully navigate this landscape—not the startups.

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7/ We're on the brink of witnessing the downfall of venture capital as we know it.

This impending collapse will take a vertical trajectory up the VC value chain, as recently envisaged by Sam Lessin. It's best to quote him directly:

Will clubby seed investing on a capital pipeline through series A to Z firms to public exist in the future — I actually think no… will the YC playbook of how to start a company and finance it work anymore? IMHO certainly not – I think the whole factory is going to be shut-down and reconstituted.

Read Sam’s whole publication HERE (via my friends at Odin).

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8/ I'm also of the belief that we're nearing the point where VC will revert back to its original niche. For a span of time, I formulated this theory I termed the Diffraction of Venture Capital. I envisioned VC gradually absorbing the entire financial services industry—either through certain VC firms evolving into the new investment banks, or established industry players departing from conventional strategies to adopt a more VC-oriented stance in the market. As per this theory, the complete economy would eventually find its financing channeled through various forms of venture capital.

I must now acknowledge that I was entirely mistaken. Not only has the VC industry suffered significant setbacks in recent times, but the surviving VC firms are those that have adhered closely to the original VC playbook. To me, this implies that the trajectory of the VC landscape, rather than undergoing perpetual expansion and diversification (the “diffraction”), will consolidate into three distinct segments:

• A limited portion of firms will either maintain or revert to the traditional artisanal approach, assembling a compact team, raising small funds, investing in a small pool of companies at reasonable valuations, and maintaining strict control over cap table and governance in an effort to achieve improbable, outsized returns. These firms will concentrate on enterprises engaged in pioneering technologies, essentially returning to the foundational roots of modern VC.

• Another subset of VC firms will specialize in B2B SaaS startups—a domain where uncertainty remains high regarding the success of founding teams, thus making room for a VC-like approach. However, unlike the preceding group, this specialization won't revolve around technological breakthroughs. Instead, it will involve supporting top-tier teams from product and go-to-market perspectives, banking on their adeptness in executing a meticulously designed and well-documented approach. In this realm, innovation takes a backseat to execution.

• Lastly, a considerable proportion of investors will need to acknowledge their inability to rightly claim the title of venture capitalists. They will forsake the excitement, no longer envision themselves as the next Don Valentine, and revert to the role of standard, boring private equity investors—allocating funds to companies that adopt comprehensible strategies across a wide array of industries, with the aim of achieving profitability through conventional avenues. While this isn't a bad thing by any means, it certainly deviates from the realm of true VC.

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9/ In this emerging landscape, where talent and capital are rarer commodities, barriers are more pronounced, and VC funding is only viable for companies pursuing technological breakthroughs or led by an extraordinary team executing the recognized B2B SaaS playbook, what fate awaits startups?

A significant number of entrepreneurs, who might have labeled their endeavor as a startup during the 2010s, will likely opt for more conservative terminology. By the way, the potential obsolescence of the term “startup” isn't inherently negative. Let's face it: haven't we encountered it far too frequently? Haven't we shared a knowing smile at the founders of low-margin, low-return web or SEO agencies branding their non-innovative ventures as “startups” to convert customers and attract talent?

Even more concerning: haven't numerous non-startup enterprises gone astray due to what I term “startup envy”? For a period of time, opting for a well-understood, well-documented, non-innovative business might have seemed less glamorous and ostensibly dull compared to being a startup tackling the challenge of uncertainty in its relentless pursuit of innovation. But in too many cases, succumbing to this startup envy yielded tangible repercussions, such as securing funding at an egregiously high valuation, almost guaranteeing future disappointment. Indeed, this, in turn, can lead to perilous and humiliating downrounds, and potentially result in a spectacular crash against the metaphorical wall, as exemplified by the once-prominent Hopin.

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10/ Does this mean that the business landscape has reverted to a state of tedium? Quite the opposite. If we attempt to contextualize this moment within Carlota Perez's framework of technological revolutions, I'd venture to suggest that the 2020s will be to the current age of computing and networks what the 1970s were to the previous age of the automobile and mass production: a phase characterized by deceleration and consolidation, accompanied by elevated interest rates, political upheaval, and geopolitical turbulence.

This is undeniably captivating. We’re entering an era where numerous sizable corporations have reached a stage where chasing market growth or relying solely on cost and price reduction has become futile. Indeed, the 1970s marked the golden age of business strategy—a collection of tools and methodologies aimed at aiding companies in securing their market position over the long term during an era of sluggish growth and scarce capital.

This decade also witnessed the inception of private equity as we know it today. The essence of private equity (which initially took the form of leveraged buyouts, as pioneered by the legendary Jerome Kohlberg, Jr., the first “K” in KKR, under the term “bootstrap deals”… in the early 1970s) lies in providing companies with the necessary capital and incentives to flourish and thrive when the three fundamental pillars of business success—propulsion by a burgeoning market, pursuing operational effectiveness, and circumventing constraints through innovation—are not as reliable as they used to be.

A whole era of rapid growth and innovation has receded into the past—the metaphorical door closing on startups. Yet, ample space remains for excelling and prospering at doing capitalism, similar to the scenario in the 1970s, when trailblazers introduced us to novel business strategy tools and methodologies, as well as leveraged buyouts. Personally, I am eagerly anticipating this new era and intend to meticulously research and chronicle its nuances in this newsletter.

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From Normandy, France 🇫🇷 

Nicolas