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Tech leaders, beware the dangers of inflation conflation

Nov 09, 2022

“Trouble is brewing for startups.”
“Startups, don’t pin your hopes on VC dry powder.”
“Why VC funding is drying up.”

Headlines like these are popping up across the business press. For some startups, these messages will serve as a cautionary sign that it’s time to revisit their strategies.

But for others, these headlines will become a comfort — a vindication, of sorts, for flagging interest. “Look,” they can say, “investment is down across the board. That’s why we’re not getting traction.”

Therein lies the danger.

VC activity is down but not out

Increasing inflation and economic uncertainty is taking its toll on public and private investing. Trading multiples for public companies have dropped from a near 3.5 average in October 2021 to a near 2.5 average today. Venture capital markets are following suit, and Q3 saw a 34% decrease in funding — the largest quarter-over-quarter global drop in a decade.

We’re seeing a definite slowing in the number of deals being done as well. Q3 saw a 9.5% quarter-over-quarter drop in total deals. Nevertheless, activity is still happening, and funds are being raised.

There’s still a lot of dry powder in the market. Fundraising by venture capital firms has continued, with strong interest from investors looking for alternatives to a declining public market. The slowdown in deal flow and decrease in spend have left some funds flush, and sentiment among some venture capital firms remains bullish.

According to the recent Web Summit survey of 142 VC firms, 60% said that economic and geopolitical uncertainty have resulted in some change to their investment strategies. That leaves 40% operating on their regular path strategically. However only 8% of surveyed firms said they’d pulled back significantly on investment activities. Market performance appears to back up these results: Even though Q3 showed a drop in number of deals, 7,936 funding deals still closed.

VC targets shifting

Investment is flowing to certain technology sectors while others slow. Cloud computing, for example, has continued to attract funding at an accelerating rate. Once sizzling web3 investments have cooled amid the crypto winter. Virtual reality — all the rage just 12 months ago — is being looked at more warily as contrarian voices at Meta speak out and monetization remains elusive. Even within sectors that are seeing strong continued investment use cases, business models and monetization timelines are affecting fund flow.

Meanwhile, artificial intelligence (AI) and machine learning (ML) investments are forecast to continue double digit percentage growth through 2025. Within the sector, however, the emphasis is shifting.

It has been a little over 10 years since IBM’s Watson beat Ken Jennings on Jeopardy. Heavy investment into horizontal platforms followed as “AI as a service” was envisioned. That vision, however, never fully materialized, and investment is decreasing for horizontal platforms.

Conversely, vertical applications in AI/ML are seeing investment surges. Vertical applications that address labor shortages are in favor, including applications that replace humans in decision making and task completion in sales and marketing, accounting and IT. Emerging AI technologies such as code completion software and stalwart AI uses such as Advanced Driver Assistance Systems (ADAS) similarly continue to attract venture funding.  

“It's not us, it’s the economy”

One cannot deny that economic uncertainty, inflation and geopolitical unrest are putting pressure on businesses, sectors and sub-sectors of all types. These pressures are playing out in the market downturns we are witnessing.

Within businesses themselves, these factors introduce uncertainty at a minimum. Uncertainty can create angst, burn energy, necessitate contingency planning, cause distraction and at times drive doubt.  However these factors can introduce another, lesser recognized, but equally serious risk: “Inflation conflation.”

When sectors or individual businesses face downturns or headwinds amidst economic turmoil, it can be easy to accept macroeconomic reasons as the cause. The market is down, the sector is down, the business is down. Seems like straight forward logic and straight forward logic is comforting in uncertain times. It can also be the downfall of a business.

Running on such assumptions can lead a business to believe their relative market and competitive position is unchanged. These assumptions can lead to overlooking, devaluing or missing the actual factors that are impeding growth.

Leadership teams need to continue to look internally at the microeconomics of their business within the framework of the macro environment. Ego can play heavily into this risk as the macro environment becomes a lot easier to see than one’s own shortcomings.

Avoiding inflation conflation

Leaders must stay humble and look at themselves and their team with a view that’s open to seeing fallibility — to seeing fault. Likewise, leaders must be willing to accept responsibility for reduced performance during a downturn.

That means challenging narratives within the organizations that position the company as a victim of the economic environment. A falling tide does not necessarily sink all ships. The reality is that some ships are sounder than others.

Leaders must continually challenge their place in their specific market space and adjust to both the macro and micro economic impacts. Ask yourself, “If we had today’s business results in a booming economy, where would we look to improve?”

How Wipfli can help

Wipfli works with tech companies at every stage in their life cycle. From product development to scaling your solution, finding investors or preparing for an exit, our advisors can help you meet your unique challenges. Learn more.

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Author(s)

Kevin Smith
Principal
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