Early Investing

Choosing Between Stocks and Startups

Choosing Between Stocks and Startups

When it comes to investing, there’s no lack of choices. The trick is making the right one. And those choices look a lot different now than they did before COVID-19 hit. Stock investors, in particular, need to recalibrate their strategies.

There are two basic options for you. 

Behind Door 1, you can choose from thousands of public-stock companies. Many are struggling during these difficult times. But only the worst hit companies have seen their prices fall drastically. Should you invest? 

You could buy the hardest-hit companies at bargain prices right now. But you’d be taking a calculated risk that they’ll bounce back. Or you could buy fast-rising companies like Zoom that have specifically benefited from the COVID-19 crisis.

But overall, public stock companies are pretty expensive. The high prices are supported by high growth. But can America’s wounded economy pick itself back up and soar once again? Maybe. But it’s going to be a while before we see that recovery.

Door 2 leads to several hundred very small, still private companies. Some are raising seed money from everyday investors through equity crowdfunding. Others are raising early-stage money from venture capital investors. These startups are remarkably inexpensive compared to the more established companies in the public stock markets. Should you invest? 

Right now, banks are lending less. People are spending less. Bankruptcies are increasing. A startup’s journey is difficult in the best of times. How will they survive, much less prosper during a global economic contraction? (Hint: it’s not as bad as it seems…)

Before I tell you which door I’d choose, let’s examine what other investors are doing.

Many investors aren’t as eager to open Door 1. The S&P 500 has fallen 5.5% since the beginning of the year. Meanwhile the Nasdaq has gone up 6.5% during the same period. Both markets have seen several ups and downs this year alone. There’s little consistency. Considering our current shockingly high unemployment rate and slowing growth, the markets have done better than I expected. But chances are that won’t last. In fact, it could get very ugly in the near future.

Things are a little more nuanced behind Door 2.

VC investors are not opening Door 2 nearly as frequently as before. A recent study (from University of California- San Diego, New York University and Harvard) says that that VC funding of early-stage companies has dropped from a pre-pandemic  average of about 112  deals a week prior to just under 70 deals a week in the first two months since the pandemic hit. The study also notes that this is typical VC behavior. Deal volume, capital invested, and deal size all declined substantially during previous recessions.

On the other hand, crowdfunders are opening Door 2 in near-record numbers. They poured $15.8 million into early-stage startups in May. Last October was the month when investment totals were higher.

In a nutshell, the public stock market is volatile. Stock prices are rising and falling drastically.  In the private market, early-stage VC investors have pulled back. But crowdfunders are stepping up their investing after a middling March.

Here’s what I think of all this…

Public stock investors desperately want the party to continue. But it won’t. Even before COVID-19 hit, the days of making big returns in the stock market were long gone. The biggest reason for that is companies wait longer than ever (and grow bigger than ever) before going public. Hot tech startups don’t go public for under $1 billion anymore – like Amazon did in 1997 at a market cap of $438 million. If you invested $500 back then, your shares would now be worth $795,096. But it’s almost impossible to find deals like that today in the public markets.

These days investors capture those kinds of returns in the private markets. Yet, VC investors have pulled back. Why? I think they fear  companies they normally would invest in may run out of cash. Usually, that’s not a problem for hyper-growth startups. Nowadays, it could be.

Achieving hyper-growth also is much harder in a shrinking economy. As a result, VC investors are  hoarding cash (despite private investment vehicles having $2.4 trillion in cash reserves, according to PitchBook!).

I suspect many early-stage VC’s are cutting back on their investing now so they’ll have more later for their portfolio companies. It has nothing to do with deals being less attractive.

That’s why I think the risk of startups not being able to raise capital down the road is way overstated.

In fact, this is a great time to invest in startups. The “new normal” is crystalizing before our eyes. Telemedicine, robotics, last-mile delivery, software enabling the teamwork and efficiency of remote workers… All of these products and services have become integral to our future needs.

Startups are also better equipped to take advantage of new consumer behaviors than startups? These companies use the most advanced technologies to solve our most vexing problems. And they often have CEOs who are born visionaries and accomplished entrepreneurs.

To top it off, VC firms are turning away highly qualified startups these days in order to stay flush. Guess where those companies are going instead? Crowdfunding, of course. The deal flow has never been better, and it’s going to improve even more.

My advice is stay away from the stock market. Startup investing is your best bet. In the throes of a pandemic, crowdfunding has emerged as one of the best investment strategies out there.

Top Posts on Early Investing