There’s been a flurry of posts so far in this new year advising startups how to deal with what certainly appears to be the beginning of an inevitable market correction (based upon your point of view, feel free to substitute your flavor of panicked adjectives for “correction”). It seems that every VC who blogs is warning that winter is coming and cautioning CEOs to store their acorns and cut back on their burn rates. All good advice.
I haven’t read much though about how to prepare for this if I’m a relatively new investor in startups. There’s a whole new breed of investors (both angel and new VCs) who have been actively investing in startups since 2010 (when we emerged from the last major recession) who have never been through a downturn as an investor. I’m writing this specifically for their benefit as I’ve been around long enough now that I’ve experienced multiple full economic cycles as an investor and started my career working on Wall Street during the crash of 1987. I’ve got a few more gray hairs today than I did then and I know some of these insights would have helped me better weather those.
To begin with, what does the trajectory look like? At the outset, term sheet valuations start contracting up and down the venture capital food chain and then they start drying up from the growth investors (except for the most compelling opportunities) as they decide to sit on their hands for a while and figure out how bad things really are. Most of the early-stage investors are still investing at this point as by nature, they’re generally a more optimistic group. I think it’s fair to say that we’re somewhere in the middle of this stage today. If the downward momentum continues, startups begin losing lower tier customers and missing their numbers. After the early stage investors start seeing this across their portfolio, they too get spooked and begin to and begin to slow their investment pace. The slide continues and soon portfolio companies are losing some of their best customers. This is when even the most optimistic investors start putting their wallets away for new investments and start asking themselves “what do our reserves look like?”
A few more months pass and eventually, large corporations begin laying off thousands of people at a time. Each time investors step on the treadmill at their health clubs, they’re greeted with flat screens showing clips describing another massive layoff. That’s when folks realize that shit’s gotten real and fear sets in. Not only are very few new venture investments getting done, but the partners at VC firms are now spending the bulk of their time working with their portfolio companies figuring out how far back to yank on the expense lever. Eventually things get bad enough that one of the top venture firms decides that we’re on the path to hell and there’s no turning back. That’s what happened on October 10, 2008 when Sequoia published this infamous deck. Pay particular attention starting on slide 41. At this point, vc partner meetings are spent discussing among themselves which of their portfolio companies they should allocate dwindling reserves to (“live”) or not (“die”).
Admittedly, nothing I’ve shared yet is particularly enlightening or helpful. Anyone who’s lived through it is probably nodding their head in agreement. Here’s where some valuable insight for new investors can be gleaned. Did we continue on the road to hell after Sequoia pronounced that we were at the gates? No, of course not. In fact, it was only three weeks later on Halloween 2008 that we reached the market bottom in the NASDAQ.
Anyone reading this who’s remotely familiar with the public markets has learned that it’s impossible to time market tops and bottoms, but you’ll be amazed at how many smart and sophisticated private investors were so spooked by Sequoia’s pronouncement, that they didn’t invest in any new companies for a very long time afterwards. I’ve even heard conspiracy theories that Sequoia intentionally sensationalized the deck to clear out investors so that they had to pick of the litter for a while. Unfortunately, those investors who throttled back missed the best pricing of startups in the last fifteen years. Even more importantly from my perspective, the “wantrepreneurs” had all gone home and none other than the most steadfast, determined entrepreneurs were starting companies at that time. In other words, the founders we as investors all dream of working with were the only ones starting companies! What I’ve learned through experience is that the very best entrepreneurs don’t pay much attention to the gloom and doom everyone else is paralyzed by. They see a pain point, they envision a solution, and they set out to execute against it. Sure, how they go about it changes, but they generally ignore what’s going on at the macro level. Finally, because they’re solving real problems, they let customers finance their early growth.
A great example of this is Isaac Saldana, the founder of SendGrid which he started in November 2008, just weeks after “RIP Good Times” was published, at the very bottom of the trough when things looked their bleakest. Isaac knew deep down that he had figured out a solution to an important enterprise problem and he didn’t wait for the lifeguards to say it was safe to get back in the water to start his company. He left his job and founded SendGrid when everybody else was running for cover. Today, Sendgrid is arguably the most important email infrastructure company in the world.
I remember a series of conversations I had with Brad Feld in 2008 about his perspective on investing through various parts of economic cycles. Brad was (and is) resolute in his belief that creating outsized returns in the venture industry demands ignoring the macro environment as it relates to investment pace. I vividly recall those conversations which helped give me the courage to lead financings in companies like SendGrid, Purch and Cradlepoint in 2009 when most venture investors were sitting on the sidelines. All three of those companies are worth hundreds of millions of dollars today.
Are we entering a minor correction? A downturn? A sustained recession? Truth is, no one really knows. One immutable truth of investing though, is that you can’t time the markets, be they public or private. What’s the biggest lesson to be learned here? Invest the same amount of capital at the same pace, year in, year out. That means don’t get greedy when prices are low, and don’t sit on the sidelines when prices are high. Investing in startups sits on the riskiest edge of the investment scale. By investing the same amount of capital in the same number of companies year in and year out, you prevent yourself from being whipsawed and having too much money invested at market tops and not enough money at the bottom.
One last piece of advice for those who have only been investing in startups since 2010. If this slide continues, it’s not going to be fun. It simply sucks coming to work every day for months or even a couple of years and deal with shitty news. Whatever you do, remember to keep this one thing in mind though. Never forget that you’ve got a portfolio of investments and that despite the degree of carnage, many are going to survive and ultimately thrive again. Now put yourself in a startup CEO’s shoes. They’ve got one egg and no basket. They’re all scared and other than the most experienced, they really don’t know what to do. You may not know either, but having somebody else in the foxhole goes a long way. Practice empathy. Spend more time with the CEOs you’ve backed and do everything you can to make their lives easier. You’ll both survive the winter and emerge with a bond that lasts a lifetime, well beyond the inevitable thaw.