Why the honeymoon is over for start-ups in Latin America

For a young entrepreneur with an idea for a digital business, the last two years have been golden. The monetary authority in the US injected $7 trillion into the financial system to soften the blow of the pandemic and interest rates were at zero, which generated a sense of invincibility in the markets. In this climate, 12 Latin American companies became unicorns last year, a term reserved for firms that are valued at over $1 billion, setting a new record for this low to middle-income region. Moreover, there were hundreds of other businesses that raised large amounts of capital from Wall Street, just falling short of this benchmark.

But what goes up must come down and now the party is over. Such an injection of capital by the US Federal Reserve generated high inflation; the Fed is now reversing course to control the rise in prices and the market has reacted aggressively. On the morning of May 20, the financial media officially declared a bear market, which involves a decline of major stock indexes by at least 20% from their highs. Inflationary concerns, rising interest rates, persistent supply chain disruptions from Covid-19 and the war in Ukraine are wreaking havoc on the global economy and consequently on its backbone, the global financial system.

Investors who once felt invincible are now seeing losses and red numbers. In the first three months of the year, funding for new businesses dropped 60% from its peak in 2021, when it reached $7.3 billion in the second quarter, according to Latin American data from analyst firm CBInsights. Meanwhile, in the first quarter of this year, the number of new unicorns reached its lowest level globally in five quarters. On top of this, not a single Latin American company had an initial public offering on the international market.

“The best way to read the market, I find, is to view it as a pendulum that swings between stories and fundamentals,” says Scott Galloway, a professor at New York University’s business school and one of the world’s most influential technology and financial analysts. “Stories, as in, the narrative, vision, and sentiment that drives the company forward. Fundamentals, as in, how the business is making money. For the past few years we’ve been deep in the story phase, and this is especially true in Latin America”.

The region had become an “assembly-line for unicorn production,” in Galloway’s opinion, boosting the global unicorn count to stratospheric levels. However, many of these companies will have no choice but to greatly reduce their operations as the pendulum swings back, and this already appears to be happening. Examples include digital companies like Netflix, which has just had massive layoffs, to smaller companies like Brazil’s QuintoAndar and Loft Brasil Tecnologia, both of which made more than 100 people redundant last month.

“The pain you’re seeing in the public markets — especially among the more narrative-driven stocks —eventually bleeds into the private markets,” says Galloway. “Many of these young entrepreneurs have spent their careers in a bull market, and have never heard of a down round. But that’s about to change. Valuations will fall, capital won’t be so cheap, and investors in early-stage companies will not feel as smart as they did a year ago”.

Criticisms and dangers

The timing for a bear market is coinciding with the difficulties that come with unbridled and sudden growth. Mexico’s Kavak, a digital platform for buying and selling used cars operating not only in its home country but also in Argentina and Brazil, went from 300 employees in 2020 to 8,500 after becoming a unicorn. But the start-up, which operates through a mobile app, is facing an image crisis after complaints from a slew of users went viral on social networks about poor service.

“Torture from start to finish,” reported one client on Twitter on April 1 in a thread cataloging her experience that subsequently went viral. Thousands added to the complaint. The noise was such that Kavak CEO, Alejandro Guerra, was forced to respond. “We are not perfect. We make mistakes; technology fails,” Guerra said at a recent conference. “We are fully aware of what happens on social networks.”

For many in countries in this region, digital startups that have grown into huge structures have failed to live up to expectations. Despite raising billions in capital, their business model continues to rely on the low wages and precarious job security which is standard for millions of Latin Americans. A report published in March by the non-governmental organizations Oxfam Mexico and the Institute for Inequality Studies (Indesig) found that the average income of a delivery driver for platforms such as Uber, DiDi and the Colombian unicorn Rappi is 2,085 pesos ($104) per week. In contrast, the companies are enjoying profits running into the millions.

These are “the shades of light and dark of an industry and a business model that is here to stay,” says Alexandra Haas, director of Oxfam Mexico. “This is why it is extremely important to flag up the situation and improve the work model used by the platforms, as well as the labor system and access to rights in our country. Companies, authorities and society in general must promote a universal social protection agenda that, on the one hand, maintains the labor flexibility desired by the delivery workers and, on the other hand, means rights are guaranteed across the board.”

This is where the big challenge lies for Latin America, according to Galloway. “Big Tech has generated enormous wealth in the US, which is something we should be grateful for,” he says. “But over the past decade, we allowed Big Tech to overrun our nation and this is something Latin America should learn from as these tech companies expand. Our biggest mistake was chronically underinvesting in our regulatory bodies, leaving private capital to emerge as a shadow government. This stemmed from a major cultural problem — specifically, our idolatry of innovators. We equate wealth with virtue and do not hold the innovator class, or their firms, to the same standards as old economy firms (or the general population)”.

According to Galloway, “the path forward in high-growth nations is to balance technological progress with respect for the rules and referees of business, i.e. regulation. Without regulation, monopolies emerge, stamping out competition and progress below. The state of American democracy in a digital era should be a warning sign for emerging nations around the globe.”