5 crucial things investors should know about timing the investment cycle

Photo credit: Sonja Langford

Understanding where we may be in an investment cycle is difficult but worth the effort. Trying to time an investment cycle, however, is nearly impossible. For early stage investing in particular, there are some important points to consider when thinking about the investment cycle.

Timing a moving target

While markets move up and down, each cycle is different. In particular, people are usually responding to what happened in the previous cycle. This includes both market participants, who tend to overweigh recent events, and the regulators, who make rules to deal with the problems of the previous cycle.

As a whole, markets are complex adaptive systems and timing the cycle is inherently difficult because of the constant change in underlying market structure.

Great companies are built through a cycle

Given the long term nature of early stage investing, most great companies require at least one cycle to create significant value. Therefore, no matter when you invest, the company will have to deal with the challenges of the full cycle in order to succeed.

Near the top of a cycle, raising money is easy for companies but getting the best talent and resources is difficult because of too much competition. Near the bottom of the cycle, raising money is difficult for companies but there is less competition for the best talent and resources. Understanding these dynamics is important for every company that wants to thrive over time.

Successful investors invest through a cycle

While it is true that valuations at the bottom of a cycle are lower, early stage investment is about the best companies, not the lowest valuation.

Sometimes the best companies are first started near the top of the cycle, so an approach of timing the cycle would miss out on investing in these companies.

In addition, by investing through a cycle, investor valuation will include cycle highs and cycle lows with the final result being somewhere in the middle on a blended portfolio basis.

Exits are when the cycle matters most

Both entrepreneurs and investors need to consider cycles most when evaluating exit opportunities. In particular, there can be a 10 times or more difference in exit valuations for similar businesses depending on the cycle.

During cyclical downturns, M&A exits are rare and it is tempting to say yes to discounted offers, especially after a hard fight to simply survive the downturn. But if the company has finally found a sweet spot in terms of growth, then it is much better to wait and focus on building value internally. The cycle will bump up valuations significantly.

As an upcycle matures, valuations will continue to increase and this means that companies may have more choices around exit opportunities. But there is no point in getting distracted by trying to time the top of the cycle for an exit. The right time to exit is when the offer simply is too attractive for the entrepreneurs and investors compared to the option of staying independent.

Exit currency is as important as market cycle

Cashing out at the top of a cycle is meaningless if you receive equity that is locked up which then proceeds to fall 99 percent in the next 6 months, which can happen at the top of the cycle.

Therefore, rather than worrying exclusively about timing the cycle, it is important to understand the overall context, and exit currency is one of the key factors to consider. While cash is an attractive alternative to overvalued equity, it is not always the best choice. Near the bottom of a cycle, receiving equity in a high growth private company may be much more valuable than cash. Thus, even though the cycle timing of the exit may be less attractive, the final result may be better. When evaluating exits, consider all factors, not simply trying to time the cycle.