The New Reality for Startups & VC in 2022
I’ll start this with a question that I’ve been thinking a lot about: which skill matters more in a founder — the capacity to dream up visionary ideas or the capability to execute on whatever is in front of them?
If you ask the collective intelligence of the private markets, the answer has changed over time. The years following the 2008 financial crisis was an exciting time in the startup ecosystem; the dramatic drop in the barrier to entry of running a company (thanks to Amazon’s cloud infrastructure product, AWS), combined with the large application surface area of Web 2.0 technology catalyzed a number of young startups, many of which either displaced the incumbents in their respective industries or created entirely new and evolutionary products and services. All these hyper-growth startups went on to deliver home run venture returns. Do the names Twitter, Airbnb, and Facebook sound familiar?
As this new era of internet technology became more promising, many venture firms became more concerned about their “anti-portfolio” than their portfolio. A perpetual feature of venture is the power law: while VCs acknowledge that a vast majority of startups fail, they are on the lookout for the one or two home run hits which can return their fund. Venture as an asset class is predicated on the long game; when LPs put their money into venture, they know they’re not getting it back for around 10 years. In exchange for this illiquidity, venture investors are expected to outperform the S&P 500 fairly meaningfully; achieving 3x returns on a fund is the bare minimum for staying in business. Just by the math of the game and playing the odds, if a vast majority of venture-backed startups go to zero, the ones that succeed must do so in a large enough way that they make up a lion’s share of the returns. With this property baked into the system, errors of omission (passing on a company that goes on to deliver huge returns) are often more consequential than errors of commission (backing a company that goes to zero). This fear of making errors of omission became visceral when venture investors who passed on early Web 2.0 startups for a multitude of reasons (too small a market, unproven product, too fringe of an idea) saw those exact same companies mature into category-defining players and deliver record-breaking IPOs. Bessemer Venture Partners has even published their anti-portfolio; among the companies they’ve missed include Airbnb, Coinbase, and Snapchat.
Events like these can often drive a change in decision processes. Early in this Web 2.0 chapter of startup activity, VCs were skeptical of the companies they saw. But as the bold founders they passed on went on to build successful companies, the same investors vowed to not repeat their mistakes. This, combined with the incredibly low cost of capital (very low interest rates) lead to an early-stage fundraising environment which became very hot (and irrational) over time. The graph below from Pitchbook is case in point: as the years went by, both the number of deals and amount of capital deployed by venture firms steadily increased. By nature, funds began to believe in founders more. They looked less for proof and more for potential. If a funding round from an exciting startup had high demand and was oversubscribed, it wasn’t uncommon for funds to overbid and bypass price discipline just to get a seat on the ship. While execution is undoubtedly important in perpetuity, the market certainly placed a high value (possibly even overvalued) visionary capacity in the time leading up to spring 2022.
Which brings us to the state of the market in 2022. Capital is no longer cheap — it’s expensive. This current macroeconomic state is a function of a number of combinatorial factors, from the massive monetary stimulus in response to COVID-19 to the war in Ukraine accelerating inflationary trends and the Fed mandate of hiking rates to tighten liquidity conditions and control inflation. Any large enough event at the macroeconomic level has downstream impacts on the public markets, with implications flowing down to early and late stage venture as well.
To draw upon a concept from physics, every action has an equal and opposite reaction. When the uncertainty around interest rates, inflation, and war heightened the unpredictability of the macro landscape, the public markets naturally reacted to this with a search for certainty and predictable near-term momentum. This has manifested itself in the prioritization of profitability and the ability to generate cash right away, opposed to previous times where the focus was on growth at all costs. The change in public market sentiment is reflected by the change in the EV/revenue multiples for many high profile companies. Shopify’s public market valuation, for example, has declined from 71x trailing revenues (pre-downturn) to 9x trailing revenues (as of this post). That’s comparable to Amazon’s public market valuation declining from 55x trailing revenues to 1x trailing revenues during the dot-com bubble.
What does this mean for venture?
First and foremost, exits happen less and less in a bear market. A huge source of exits and returns for venture investors are the IPO markets and M&A activity. The current downturn has slowed down both the pace at which IPOs are happening and the magnitude of the IPOs. 2022 IPO proceedings are down a staggering 95.3% from 2021, and is on pace to be the worst IPO market in two decades. This, combined with a cool down in M&A activity, lowers the number of possible exits and thus, makes venture as an asset class more illiquid than it already traditionally is.
Adding to that is the denominator effect: when LPs allocate capital to different asset classes, they tend to put a majority of their money in the public markets due to liquidity and visibility, and a smaller portion in the private markets (venture capital) for the possibility of outsized returns (LPs also allocate capital towards fixed income and private equity among other asset classes, but for the sake of simplicity we’ll keep this example to just public markets and VC). Say an LP is managing a $1 million portfolio, they are likely to put $900,000 in the NASDAQ and $100,000 in venture funds, such that they have 90% of their money in the public markets and only 10% in venture. But when the public markets experience a downturn, what happens to these equity positions? In the event that the NASDAQ goes down 20%, the portfolio is now worth $820,000 — $720,000 in public equities and $100,000 still in venture (illiquid, especially now). All of a sudden, the portfolio is more heavily skewed towards venture, with money allocated towards venture accounting for ~12% of the portfolio and money in public equities accounting for ~88%. When this happens, LPs want to rebalance their portfolio, but the illiquidity of venture makes this near impossible (in some cases LPs sell their positions in venture to secondary markets, but this is not too common). LPs respond to this imbalance in their portfolio by putting less money into venture, halting investments in new funds and often not even wanting to invest in the funds they’ve already committed.
This has driven a sea change In the mentality of venture investors, with it all boiling down to two words: more discipline. With the high likelihood of less capital flowing from LPs for future funds due to the denominator effect, GPs have a tremendous amount of pressure to make their current funds count and thus, have a lower appetite for risk. This means more discipline both in terms of which companies they select to invest in and the price they pay to get into a given round. The biggest indicator of this is the increase in due diligence that is being performed by funds. As David Thévenon, a partner at Balderton Capital, said back in June: “Last year, rounds were closed sometimes in a matter of days, but companies need to realize that isn’t going to happen now. We’re going to ask a lot more questions, particularly around things like cash burn. With the new state of the market, raising money will take longer and it’s not going to be as easy.” More due diligence and less deals being made reflect the buildup of dry powder (money raised but not deployed) for VC funds; data from Preqin Ltd shows that dry powder has increased by more than $100 billion globally since the end of 2021 and reached almost $539 billion in July of this year. Capital is still there, yes, but the threshold needed to be met for investors to part ways with their money has risen in a meaningful way.
Let’s return to the founder trait topic which we began this piece with: which quality matters more in a founder — visionary capacity or execution capability? In a market like this one, efficient execution is valued more than ever. Not just execution in being able to get their product to market, but execution in the sense of being able to make enough revenue to survive in a tough fundraising environment. Gone are the times when founders could draw up a blitzscaling growth strategy and see it fail to meet expectations, only to be able to raise another venture round in a matter of days; the core objective function for startups right now is simply staying alive and being able to make the most of the cash they have on hand. Being able to do more with less. As Insight Partners managing director Hilary Gosher has said, “There’s always capital for good companies, but with the uncertainty, if founders don’t need capital, there is no reason to raise.”
I fundamentally believe that this is a market correction; a filtration mechanism that is embedded into the evolutionary process of all complex adaptive systems, with the objective function of getting rid of the noise while doubling down on the signal. As Lux Capital partner Josh Wolfe wrote in his Q2 2022 LP letter, “what may feel like a climax of chaos may yet yield a denouement of detente. After the tension, the muscle relaxes. The house of cards collapses to the ground, but the gold-painted brick is out in the world, its full meaning and value to be discovered.” Benchmark partner Eric Vishria has echoed the same sentiment: “All the pretenders and the speculators will get wiped out. We’ll have the believers and the builders.”
An economy of excess drives exuberant abundance; this leads to the capacity for multiple high-upside ideas to be tested without the guarantee of a positive outcome. In bull markets, many of the ideas tested go to zero, but the ones that succeed make up for all the losses. In a bear market, on the other hand, constraints breed creativity. The companies that not only survive but thrive in this downturn will be the ones that are antifragile. The companies who leverage this market correction not as a death sentence, but as a crucible moment to innovate on multiple key dimensions in the search for better ways of operating. To find better spending and customer acquisition practices such that burn multiple (cash burned divided by net ARR added) is minimized. To find newer product development strategies such that product adoption continues to rise even when customers are spending less. To, amidst the rationalization of company headcount and hiring strategies, find the brilliant people in the organization (people are a power law) and give them more responsibility such that they can play a key role in the navigation of these choppy waters. In good times, it’s easy to get complacent; market meltdowns like these give companies a manifesto to innovate and think differently. The truly great companies relish this as an opportunity to rise.
In fact, some may go so far as to say that for these great companies, a bear market is a better environment than a bull market. As Benchmark partner and legendary VC Bill Gurley has said back in 2017: “A good entrepreneur is systematically advantaged in an environment where it’s tough to raise capital. I would go as far as to say that you could have 60 years of business experience. You could be Jack Welch. You could be Warren Buffett. You could be [Jeff] Bezos. And it doesn’t prepare you for a world where your less talented competitor can afford to lose $300 million next year and maybe the same the year after because of all the money they’ve raised. There’s no rule book for that world.” In a data-driven world, it’s so easy to subconsciously judge and evaluate a company based on how much money they’ve raised in a given round. But, in reality, what truly matters is not how much capital a startup can raise, but what they do with that capital in their war chest.
It’s important to realize that, in this constant search for rationality, entrepreneurship is an inherently irrational activity. The decision to start a company is an economically and mathematically irrational decision. Startups, in the aggregate, have a 90% chance of failing. With the upside of a successful outcome impossible to be known, the expected value of such a decision is net negative. Classical economic theory would say that founders are crazy, even though successful startups tend to be a valuable source of economic growth. This leads us to recognize that a bubble is not just the mispricing of financial assets — the market activity is just a manifestation of its true definition: an objectively irrational shared belief in a better potential future. Bubbles reveal themselves not just in people bidding up asset prices, but in the very act of people starting companies and building products in pursuit of a better version of the world. In fact, Byrne Hobart has made the argument that even Apple’s development of the iPhone was the result of an internal bubble, writing the following:
“The first big smartphone bubble didn’t show up in stock prices; it was Apple’s conviction that a fully featured, touch-based, internet-connected device could be put in the hands of millions of consumers for a few hundred dollars. When Apple started working on the iPhone, this conviction wasn’t fully supported by the facts. The first demos of the touch interface, for example, were incredibly clunky, but it was rapidly refined into something that worked the way it should. The more implausible it is to achieve a given combination of useful product features, the more impressive the result will be. So part of the task of any organization doing deep research and/or development is to keep the team convinced, against all odds, that they’re not wasting their time. This puts another perspective on Apple’s vaunted secrecy: It wasn’t just that they wanted the launch to be a big deal, but that they didn’t want the iPhone team to get honest and informed feedback from people who didn’t think it could happen.”
Here lies the paradox of venture investing: the goal is to assess value as rationally as possible in order to maximize returns for LPs, but at the same time filtering out all ideas that seem irrational can prevent one from betting on home-run companies with products like the iPhone. Great things take time to marinate, and progress is often nonlinear. It’s why startups don’t (and shouldn’t) have quarterly earnings calls as public market companies do; short-term accountability and visibility are traded off for the long-term vision and belief in a potential product and strategy that could drive substantial economic value. Taking a step or two back in order to go ten steps forward is a necessity in the startup world, even if it means being misunderstood by the general public.
As author F. Scott Fitzgerald has famously written: “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.” Now, more than ever, does this idea apply to the startup and venture ecosystem. There has never been a formula to building a successful company, especially not in a downturn like this. The key to surviving and thriving in conditions like these is being able to both have more discipline in making the tradeoffs that can be made while continuing to hold conviction on the focal points that make the company what it is. As Vinod Khosla often says, “be obstinate about your vision, be flexible about your tactics.” In a downturn, the tactics have to change; this does not mean the vision should.
What this truly comes down to, beyond anything, is leadership and the “why” behind the company. The ability to stay obstinate and maintain a deep-seated conviction for a long-term vision is incredibly rare, especially when a macro environment like this changes almost everything about what the day-to-day looks like. Mercenary founders will quit. Missionary founders will rise to the challenge. It’s as simple as that; the “why” behind an entrepreneur’s journey to start a company really reveals itself when the founder is tested in such moments of wartime. And that same fundamental purpose underlying the company, the world that the founders want to create, is what serves as the catalyst to rally the troops and unite the team when the going gets tough. Fundamentally, every startup is a bet on what the world should look like, and how to build that future into fruition; the problem that the startup is solving is the delta/gap between what they think the world should look like and what the world currently is. The collective level of determination for building that version of the world that doesn’t exist today is ultimately what’s going to decide whether the startup adapts or perishes in a downturn.
