The dynamic interplay between economic cycles and startup funding is an area for investors to understand. Whether you’re a venture capitalist, angel investor, or part of a corporate investment arm, understanding the cyclical nature of the economy can help you make more informed decisions and anticipate opportunities. This blog will discuss economic cycles and startup funding and how one could navigate these cycles.

Economic Cycles and Startup Funding

Understanding Economic Cycles

An economic cycle refers to the fluctuations in economic activity over time. These cycles can be influenced by a wide range of factors, such as fiscal policy, interest rates, geopolitical events, and technological changes. In a globalized economy, disruptions can be felt far beyond the borders of any single country, making it important for investors to stay connected to both local and international trends. The cycle typically includes four main phases[1]:

Expansion

This is the phase of growth where GDP rises, businesses experience higher revenues, and consumer confidence and spending increases. It’s often marked by low unemployment and higher productivity. During this phase, investors could be more willing to take risks, therefore there is a possibility for increased availability of capital.

Peak

The peak is the transition point between expansion and contraction. Economic growth starts to slow down, but markets may still be increasing. Investors may be more cautious but still choose to seek opportunities[2].

Contraction

A contraction is marked by a contraction in economic activity, decreased consumer demand, and rising unemployment. In this phase, the risk appetite of investors can shrink, making it harder for startups to secure funding, particularly at high valuations[3].

Trough

The trough is the bottom of the cycle where the economy stabilizes before beginning to recover. This period is generally recognizable in hindsight, but harder to spot in real-time. Early-stage startups may struggle during this phase, but it can also present unique investment opportunities, especially in emerging sectors or distressed assets[4].

Economic Cycle Trends

Look at this graph of the economic cycle trends from 1960 to 2019. You can see the four major trends throughout the years since 1960. In this graph, the “slowdown” period is also called the “peak,” and that phase, alongside the expansion phase is typically the longest period in the cycle. You can also see the times of recession, most notably in 2001 and 2008[5].

Impact of Economic Cycles on Startup Funding

Expansion Phase

During periods of expansion, investors generally are more optimistic. Funding could flow freely into startups, particularly those that demonstrate scalability and have strong potential to deliver growth in an expanding market[6]. The increase in capital and the desire to back the next “unicorn” may often lead to higher startup valuations. However, this can also lead to a “bubble-like” environment in some sectors, which can be problematic when the economy enters a downturn.

Startups with growth potential in expanding industries, such as technology, healthcare, or clean energy, may find it easier to secure funding.

Peak Phase

While the economy is still strong, some investors may become more cautious as they anticipate an impending downturn. Startups can find it slightly harder to secure funding, and valuations could decrease in this phase. Some investors could begin to tighten their belts and focus on startups with proven business models, established revenue streams, and lower risk profiles. There may still be substantial capital available, but investors are likely more selective.

This phase can see activity in later-stage rounds, with investors focusing on startups that are close to profitability and have demonstrated resilience.

Contraction Phase

During a contraction, venture capital activity can slow down. Investors might choose to pull back, leading to a tightening of available capital. Seed funding and early-stage investments can be particularly hard to secure during this phase. Investors may prioritize more conservative, established businesses, preferring those with solid revenue and minimal exposure to economic volatility.

Contractions can offer acquisition opportunities for larger companies looking to acquire distressed startups at a discount. In these times, startups that have already raised significant capital might look to venture debt or bridge funding to stay afloat, especially if they’re unable to raise another round of equity funding.

Trough Phase

As the economy begins to stabilize, the trough can offer unique opportunities for investors. Early-stage startups with a viable business model and solid fundamentals can become attractive at discounted valuations. Investors who have a longer-term view could identify startups with potential upside once the economy starts to recover.

This phase can mark the beginning of the next phase of expansion, and investing during the trough could set the stage for growth[7]. The trough often sees the birth of new opportunities. Economic crises can spur innovation, and in these times, investors might find opportunities in industries such as fintech, edtech, and health tech, where disruption can take root and grow during an economic recovery.

Navigating the Cycles

Diversification

Economic cycles are inherently unpredictable. A phase of rapid expansion can be followed by an unexpected downturn, and the exact timing and nature of these shifts are difficult to forecast. Investors can choose a mix of sectors that may not all respond to economic conditions similarly. For example, while tech startups could be vulnerable during a recession due to capital tightening, industries like healthcare, essential services, or e-commerce may experience less volatility. By spreading your investments across multiple assets, you can help mitigate risk. However, it’s important to remember that diversification does not guarantee a profit or protect against losses.

Investing During Contractions

Contractions often lead to tighter funding environments, but they can also present unique opportunities for investors. Many successful companies were born during or shortly after the contraction period because economic downturns can force businesses to innovate, become more efficient, and adapt to changing consumer needs, often leading to the emergence of disruptive business models[8].

Building Relationships

Startups are not just about the idea or product; they are also about the people behind them. In times of economic uncertainty, strong relationships with founders may become even more critical. Investors who actively support their portfolio companies with strategic advice, introductions, and operational help can make a difference.

By staying closely connected with portfolio companies, you may be able build stronger bonds that will help you navigate both good times and bad.

Leveraging Data

Data-driven decision-making can be important, especially in times of economic uncertainty. Access to quality market intelligence, trend analysis, and financial forecasting can allow investors to make more informed decisions about where to allocate capital. It also helps identify emerging sectors that may not yet be on the radar of the broader investment community[9]. A data-driven approach can help you equip yourself to identify potential opportunities

Adapting Strategies

The economic environment can change rapidly, and your investment strategy may need to be flexible to respond to those shifts. For example, during an economic expansion, investors might focus on high-growth tech startups. In a recession, they might prioritize businesses with strong cash flow, proven business models, and minimal reliance on external capital.

While some startups can take longer to grow during a contraction, the recovery phase may create opportunities. Having flexability can allow for some investors to participate in opportunities during market recoveries and shifts in consumer behavior.

Final Thoughts

Navigating the complexities of economic cycles can help you make more informed decisions. Understanding the phases of the cycle and their impact on funding can help investors research opportunities. Whether the economy is in a period of expansion or contraction, some key ideas to consider are maintaining flexibility, staying informed, and adopting a long-term view.

Want to learn more about raising money for your startup? Check out the following MicroVentures blogs to learn more:

Are you looking to raise capital for your startup? MicroVentures may be able to help. Apply today to start raising capital with MicroVentures!

APPLY TO RAISE CAPITAL

[1] https://www.investopedia.com/terms/e/economic-cycle.asp

[2] https://www.ssga.com/library-content/products/fund-docs/etfs/us/insights-investment-ideas/sector-business-cycle-analysis.pdf

[3] https://www.4degrees.ai/blog/private-equity-during-a-recession-opportunities-and-risks

[4] https://www.investopedia.com/terms/t/trough.asp

[5] https://www.ssga.com/library-content/products/fund-docs/etfs/us/insights-investment-ideas/sector-business-cycle-analysis.pdf

[6] https://artafinance.com/global/insights/thinking-in-private-equity-investment-cycles#heres-some-more-good-news

[7] https://www.britannica.com/money/stages-of-economic-cycle

[8] https://www.investopedia.com/terms/e/economic-cycle.asp

[9] https://www.hiltoncapitalmanagement.com/blog/navigating-economic-cycles-for-better-investing

*****

The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.

MicroVentures Blog