In the bygone decade of ultra-low interest rates, quantitative easing, and a consequent boom in equities, venture capitalists (VCs) and tech start-ups had it easy. There was a lot of money chasing a lot of tech ideas, and venture capitalists did not have to make money from investing in tech start-ups immediately. But once the concept had taken shape in society, the tech start-up would already have a near-monopoly position, and the profitability of the start-up would become immense.

This winner-takes-all investment strategy relies on a large number of subscribers and network effects. For example, in terms of platform economies like Netflix or Uber, the more users on a platform, the greater the platform will be due to data feedback incorporation, which in turn increases user engagement and the number of users.

The assumption of a hockey-stick growth curve was key to this proposition, and VCs chased after the next Apple, Google, or Meta. Losing the odd several hundred million is not a disaster if you manage to invest in one of these successful tech start-ups, which scaled to become a fully-fledged Big Tech company.

However, this led to a great deal of wastefulness from VC firms, which is coming to light now as a recession is looming, inflation is sky-high, interest rates are higher, and many of these tech start-ups are on the brink of failure. Now, amid economic peril where operations have become more expensive and financing has become tougher, the appetite for subsidizing loss-making is waning. Moreover, the ability to scale companies with network effects and economies of scale is a significantly bigger challenge in a stagflationary environment.

Ultimately, the failure of venture capital-funded tech start-ups tends to fall into one or more of three categories: overambitious market entry attempts, choosing utopia over utility, or reinventing the wheel.

Tech start-ups and unrealistic market entry attempts

Markets are controlled by humans, and humans are emotional creatures. As such, market movement can be attributed, at times, to emotions rather than simply economic realities. The fear of missing out (FOMO) is a great example of emotions driving the market value of companies to stratospheric, unrealistic, and unsustainable levels. Just take the EV market.

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Venture capitalists (and every other investor) did not want to miss the next Tesla, and consequently pumped gargantuan sums of money into EV companies like Rivian or Sono Motors. Two of the top three largest funding rounds for US start-ups in 2021 were for Rivian ($2.65 billion in January and $2.5 billion in July). Rivian reached a share price high of $172 in November 2021, before falling to a cold-hard reality price of $20.60 in May 2022—by the latter date, Rivian had sold a total of 2,148 cars.

Ultimately, the automotive market is highly competitive and low-margin, billions are spent on R&D each year by established companies that have carefully built brands and supply chains over a long period of time. To think Jeff Bezos and co., backed by an army of venture capitalist firms, can disrupt an industry in the space of a few years is ludicrous.

Creating utility or utopia?

There is another reason for the failure of several heavily venture-capital-funded tech start-ups. Many simply do not offer something essential to consumers. Many of these companies are unprofitable not because they are early-stage, but because they offer something that is essentially a luxury service for everyday consumers. If necessity is the mother of invention, then surely decadence is the mother of imprudence too. When recession hits, luxury businesses that are of little use to consumers will find it hard to survive.

For example, consider ultra-fast, urban-focused grocery delivery services such as Gorillas or GoPuff as examples. There are over ten of these companies competing in quick commerce across Europe. Over half started during the pandemic and they have collectively raised $2 billion in funding. In 2021, GoPuff reported an EBITDA of -$150million from $340 million in revenue and has now started to close parts of its operations and lay off staff. Getir and Zapp have reduced their staff by 14% and 10%, respectively.

You will not find many inner-city residents of any European metropolis that are not within a 20-minute walk or five-minute drive to a grocery store. Quick commerce might be appealing in a cash-rich, time-poor world—or perhaps a pandemic world, where going to supermarkets brings public health risks, but a recession will cause many to be cash and time-poor. Getting groceries delivered in less than 20 minutes becomes less justifiable in times of recession. In other words, opulence does not fly in a cost-of-living crisis.

Reinventing the wheel

At its peak, Klarna reached a valuation of $45.6 billion before crashing to a valuation of $6.7 billion in July 2022. It is not the only buy now pay later company to have crashed by over 85% in just over a year. Ultimately, BNPL companies offer loans and not much else.

For Klarna to be valued higher than Santander, Lloyds, or Capital One, is frankly insane. Moreover, it is quite predictable that PayPal, Visa, Apple, and other established tech companies can offer similar solutions for consumers who are already in their tech ecosystems and have the capital to perform predatory pricing, knocking smaller BNPL firms out of the market. Big Tech has often used this tactic, most notably selling voice-activated home speakers at extremely low prices to knock out the competition.

For some time, venture capitalists have been drinking the Kool-Aid, but now we are in an entirely different macroeconomic environment, and that might not be a bad thing for VC firms. In other words, a recession might just cause venture capital and tech start-ups to become much more laser-focused on solving more important problems in society, which in turn lead to more profitable ventures.