What Markets Mean for the VC Industry
VC’s are taking to twitter to brag about how agnostic they are to the markets. The rhetoric goes: “bad firms are pulling term sheets and falling down, but good firms are ‘business as usual.’”
My view is that:
These VC’s are either using the virus to market their firms stability, knowing that there will be some affect, or they are truly clueless.
The truth is in the middle.
Yes — it’s true that funds have a lot of dry powder right now. I don’t see rounds falling apart, or a freeze on new funding. For example, we are closing a large (for us) round on Monday. Sigs are in escrow and will be released Monday morning once we have signed docs from existing noteholders and stockholder consent docs. We also have 3 other signed term sheets with companies. We intend to close each — just like normal.
On top of that, we invest out of discretionary vehicles. Which means our LP’s are obligated to fund us. Most of our LP capital is from institutional investors unlikely to have liquidity issues at this time. This helps.
Historically, when we want to size up on a deal we would raise SPV’s to co-invest with our funds. We’ll likely avoid doing this for fear of funding risk in the next few months.
But while existing deals are closing, and good companies will be able to go out and raise new rounds, there, without a doubt, will be some significant impact.
Why will a recession affect Venture Capital?
(1) M&A is going to slow down. Often, M&A is a backup plan for companies not growing quickly enough to raise another round — and it offers a soft landing or “small win” for a significant part of a portfolio. Companies that may have otherwise relied on M&A will rely on bridge rounds from their investors — which is going to require more of available capital than before. This means more capital focused on existing portfolios instead of new deals. Which means less capital will be available for new startups. Luckily, there is so much dry powder right now, that on a relative basis things will be okay, but until we know how bad things are, I bet a lot of VC’s will hold more reserves than normal.
(2) Top-line growth rates of companies will slow down. Startups rely on 50%+ (and usually 100%+) growth YoY to raise their next rounds. But top-line will slow. Enterprise sales will likely come down, travel/in-person meetings will stop making sales harder, any hospitality company or business relying on live events will get hurt. The millions of people who work in retail, on hourly wages, or in face to face jobs may get laid off, also meaning consumer demand will come down. This could hurt D2C companies. In short, this demand will come back, but a slow down of top-line will lead to less clean of fundraising stories and more insider rounds. Locking up dry powder. The uncertainty of how long this last means “business as usual” is not the right approach. If I was a portfolio company of a fund, I’d want to know they were focused on me first and new deals next. No matter how much dry powder the world has.
(3) Startups will not lay people off unless they have to. Most managers have only lived in good times, don’t want to deal with bad optics, and will hope/assume the slowdown in demand is temporary. This is likely true, but it’s not a group of operators who know how to make quick adjustments, and it’s important VC’s have conversations with their portfolio companies of what the plan is if this last 6 months, or 8 months, instead of 3.
(4) Some companies will grind to a complete hault. Restaurant-related startups will be hit hard. Live event startups/ticketing companies will hit hard. Think dog walking companies, sports-tech startups, Airbnb management companies, consumer lending companies who see high default rates, etc.
(5) Comp multiples will come down. VC’s often value businesses based on where they think they’ll end up 3–5–10 years out, and on what values those businesses should receive based on comps. Since public market comps are worth less, startups will receive lower valuations.
Basically — this isn’t the end of the world and the VC industry might be better positioned than its ever been for a downturn.
Like many other VC’s — we expect this to maybe end up being an amazing vintage to launch a fund and I bet we invest very actively in Q3 and Q4 as things shake out.
On top of that, markets still aren’t that cheap. They’re back to 2018 levels (although that doesn’t really consider earnings growth since that point) and we’re probably not at a bottom.
But “this doesn’t affect us, only Wall Street is going to get burned” is just a dumb attitude and shows a lot of ignorance.
What Can Startups Be Doing?
Try to make sure the VC’s who have backed you are stable — have dry powder, and if you have raised via SPV’s — try to get access to the investors in those SPV’s so that they know your plan and that you have their buy-in.
Don’t lie to yourself. If growth is going to slow, declare it now, set expectations. And manage budget accordingly.
Use this quarter to cut out fat. If you had been thinking of letting someone go, seeing a loss in a loan portfolio, or cutting something you always wanted to cut, you have your excuse. People will look at this quarter with an asterisk. Take advantage of that and if things are going to be bad at some point, make this the quarter where that happens during a time people will give you the benefit of the doubt for.
If you are in the middle of raising a round — close it now. We don’t know how much worse this might get. You might get sick, your VC might get sick etc. Just close.
Write a well thought out update to your investors. Something they can pass to their LP’s. One day, if you need a bridge round, it’ll be eaiser for the VC will over extend themselves if their LP’s are supportive of the company. For many VC firms this doesn’t matter — they have such good relationships with their LP’s that they can do whatever they want. But if your VC’s are newer, less established etc. this will go a long way.
Don’t overreact, just stay sober, be honest with yourself, don’t lie and say everything is fine if it’s not, and keep your head down and keep building.