It was October 19, 1987. I had started my career two months earlier as an articling student in the securities department of the (then) law firm of Goodman, Philips & Vineberg (now Goodmans), one of the leading corporate law firms in Canada. On October 18, 1987, I had on my desk the draft prospectuses for 10 active IPOs that our firm was working on. On October 20, 1987, my desk was clear of prospectuses…for another two years.
I have been thinking about October 19, 1987, as I watch what has been happening over the last six months in the public and private markets. Depending on how one defines a downturn, the current one is either my fifth or sixth. So, I thought it might be helpful to share some of the learnings that I had from previous downturns with those who have yet to have the “pleasure” of experiencing one.
1. Perspective, Perspective, Perspective
The venture industry is the most “manic-depressive” industry in existence. Either the sky is the limit, or the sky is falling. However, the reality is that it is never as good as people claim nor as bad as people feel. The sure sign of when a market has hit its height is when people who have never experienced a downturn start telling experienced investors who are worried about the cycle that “this time it will be different…cycles are over”. The sure sign of when to buy is when some of the same people start talking about how the venture model is “broken” and that all the “great innovations” have already occurred.
The first thing I learned is that cycles are part of the business. The good news is that cycles also have an upswing, so perspective and patience are two of the most fundamental elements every VC needs during times like these.
2. The Best Entrepreneurs Shine
It is never easy to be a CEO-entrepreneur. But, when capital is plentiful and the markets and the economy are only rising, it is a lot easier. In up-markets, a lot of marginal companies get funded. The quality bar gets lowered, and the valuations move higher. Some entrepreneurs start raising at valuations that are driven by short-term ego (“Look at me! I started a unicorn!”). Venture funds start investing based on how much they have to invest and not how much the company actually needs. Capital efficiency goes out the window….
And then…the downrounds start coming and the heavy preference stack starts falling like an anvil…And who is at the bottom of the stack?: the entrepreneurs, the employees and some of the VCs who pushed to raise as much as possible at as high a valuation as possible. Employees find their options are way out of the money and see the downround as evidence that they are working for a struggling company (whether or not it is actually struggling); they start looking for new jobs. Tension around the boardroom table only heightens….it usually does not end well.
But it is at this very moment that the great entrepreneurs shine. The great entrepreneurs care (and always cared) about bringing value to their customers, product-market fit, unit economics, proving the model before raising too much money, sales efficiency and raising at a valuation that was reasonable and that would not force them to raise in a downround subsequently. In a downturn, the great entrepreneurs who built their companies right find it far easier to recruit great people. They also find that in a downturn they no longer have 50 competitors as many of the marginal companies no longer get funding.
It is therefore not surprising that some of the greatest companies of all time were founded and funded by VCs within two or three years of a crash or went through the crash when they were still very young…Amazon in 1994, Sales Force in 1999 and Facebook in 2004. In a down market, the strong get stronger and the weak get weaker. Not surprisingly, it is periods like these with entrepreneurs like these when VCs generate their best returns.
3. The Disappearing Overhang and the Implication for GPs
It is a fact that 2020 and 2021 were great years to raise venture funds. Many funds were able to raise capital, including many first-time funds, and second-time funds that had yet proven the ability to generate realized returns. Why?
Institutional investors, whether pension funds, insurance companies, endowments or foundations, work on the basis of percentage asset allocations. They allocate w% to the public markets, x% to real estate, y% to fixed income and z% to private equity and venture, etc. As the value of their assets go up, the absolute dollars that they allocate to venture increases. Many institutions feel pressure by their boards to deploy that allocation quickly. But, as it is very difficult to scale venture funds in the same way private equity funds scale and still make money (size is the “enemy of returns” in venture), it is often very difficult for many institutional investors to access the truly best, proven venture teams — the top decile. The top decile funds consistently attract the best entrepreneurs and bring the most value to the table and do so cycle after cycle after cycle. The difference between the top decile and median returns in venture is huge. In fact, if one’s venture returns hug the median over time, it is hard to justify the allocation when compared with the risk.
What happens in a down market? Institutions experience the “denominator effect”. As the public market and the liquid asset values start to decline, the total asset value managed by institutions also starts to decline. Liquid assets are marked to market. And venture assets? Many funds keep valuations at or close to the last round; they are not marked to market (until their auditor forces them to lower valuations, typically in the year end statements) and remain at the high values of last year. If an institution is close to reaching its full allocation to venture, in a public market decline, their actual allocations usually exceed their planned allocations. Not only do they stop making new commitments, but they also start looking for ways to sell some holdings, particularly those that are low funded and are “eating” cash and not “generating” it.
The implication is that the proven venture teams are able to raise capital (and often are over-subscribed) and the teams without a proven track record cannot raise at all. Many of the teams with 2x MOICs that believe that they are doing well will find a frosty reception from potential limited partners. Even some managers with great TVPIs and weak DPIs will face some serious questions from LPs…if they could not return money in the greatest bull market in a century, why should an LP think that they can convert their high TVPI into DPI in a dead IPO market and with M&A priced on the basis of lower comparables. The result: a form of “fund purgatory” for many. And those that decided to invest their funds in 18 months (and in some cases less) and kept limited reserves will also find themselves largely “out of the game”. It is much harder to raise “opportunity” funds, annexes and SPVs in a downturn.
Not surprisingly, the first thing that many experienced funds do in a downturn is start organizing extension rounds for their better portfolio companies. Of course, they too participate, often to their pro rata. Between the extension rounds and the inability of many funds to raise at all, the “overhang” disappears very quickly — typically within 18 months of the beginning of the market decline. The patient VCs who did not run through their money quickly will be the big beneficiaries as the dry powder dries up.
4. The Valuation by Stage Decline Lag
Typically, the first to leave the venture investing world are the cross-over investors. After a public markets’ decline, it is often cheaper to buy stock in innovative public tech companies than their private equivalents, largely because of the rather incongruous “liquidity discount”. As such, the investors whose mandates allow them to invest in both the public markets and private markets shift their investing to the public markets. Less money chases late-stage deals and late-stage prices start going down, eventually to the “downround” level, and the public and private markets close the gap.
This often leads to a domino effect that takes typically a year or more to reach its completion. As the cross-over players leave the market, the B round investors start doing C, D and later stage deals as the prices have declined and they can get proven companies at good prices. As many of the A round investors raised very large funds, they start moving in to fill the gap in the B round and start doing B round deals, etc. The larger seed funds start doing A round deals for the same reason. And, what happens to seed investing? It gets tougher and tougher to raise seed money. Angels who have been hit by the public market decline and find themselves putting their hands in their pockets to support their current portfolio have neither the capital nor the appetite to do more angel investing. Often, the newer funds without the track record who have a hard time raising capital are seed funds. Seed entry prices then come way down…Therefore seed VCs who do succeed in raising capital and judiciously investing it do so well in these environments.…
5. Overcompensating for the Decline
Overfunding in an up-market ends badly. Underfunding in down-market ends equally badly.
Venture is all about “elephant hunting”. It is a combination of large ownership and letting the winners run to become the big, sustainable companies that they should be. The best performing funds have huge stakes in their best companies and those best companies become market leaders in huge markets.
But a company cannot become a market leader in a huge market if that company is starved. Our friends and partners at Meritech wrote a very insightful piece (as they typically do) about this point called: “2022 SaaS Crash” (https://www.meritechcapital.com/blog/2022-saas-crash). As they correctly point out, cutting for cuts sake is not a smart strategy. A board must optimize to achieve the best kind of growth for the money. As Meritech correctly pointed out, “the best companies pull ahead in down markets.”
In our experience, pulling ahead means using a financial crisis as a period to “roll up” — buying struggling, “feature companies” to speed up execution of the product roadmap, often buying instead of always building. As the competition gets weaker, a startup can accelerate market penetration and become the market leader much faster than it ever dreamed. Expect a rush of private M&A deals next year. For venture investors, being smart and selective about what companies to cut and pushing the follow-on capital into the ones that can become the winners will yield the best returns.
6. Denial of the Decline
Some inexperienced investors become so shocked by a down-market that they become akin to “deer in the headlights”, unable to act. Some others go into denial. One of the most common aspects of investor denial is believing that all challenges can be overcome by more funding. And down-markets often lead to good money being invested after bad. So, just as starving the winners is a problem, gorging the losers is a recipe for poor performance. One of the toughest challenges of being a venture capitalist is triaging a portfolio. But, triaging it must be to ensure that capital is invested in the winners. As noted above, in a down-market, the strong get stronger and the weak get weaker.
What All This Means
Based on history, it will likely get worse before it gets better. However, just as it was not as great as some claimed during the last few years, it will likely not be as bad as some claim over the coming years. Unlike other financial crises, we are going into this downturn with a host of huge opportunities that were accelerated by the Covid epidemic. Remote healthcare, robotics, supply chain technology, education technology, agricultural and foodtech, cybersecurity and other areas have gotten a huge boost by Covid and its aftermath (if we can actually say that we have reached “aftermath” status). Moreover, there are technologies coming out that are more disruptive to existing industries than in the past. Many of the changes that will occur will be revolutionary, not evolutionary. Another significant difference from past crises is the relative ease of access to potential customers; business software was sold historically in onsite visits, while huge deals are now completed through inside sales — much faster and much more inexpensively. The combination of all these factors together with less money running after deals and greater availability of better people and fewer competitors making “noise” should make the next 3 to 5 years a fabulous time to seed and to invest in tech startups. In many ways, we are just at the beginning of a huge wave of innovation and disruption, not at the end. A lot of money will be made. So much for manic depression….
Alan Feld is the Founder and Managing Partner of Vintage Investment Partners (www.vintage-ip.com), a venture focused fund of funds, secondary fund, and growth investment group with $3.5 billion under management.
Get in touch with Alan Feld:
