{For a Smart, Experienced Investor,} Recessions Aren’t Always Doom and Gloom

by Phil Herget

It has been an incredible 13 years since the last recession ended in 2009. Nearly 275,000 new startups have been funded and many new Venture Capital firms have emerged — lots of these started by people who have never experienced a market downturn. As we near the inevitable, there are many lessons from the Dot-Com collapse of 2001 and the financial crisis of 2008 that my partner and I have been reflecting on to prepare our firm and portfolio companies for turbulent economic times. Back in 2001, we were exuberant, young VCs caught up in the go-go moment. And, we were shocked by how bad things became and how quickly.

We are not writing this as a doom and gloom scare piece — but rather to impart some of the lessons we took from the last two market downturns and how to leverage those lessons in the current market rationalization. One of the key lessons learned is that these downturns do cleanse and rationalize the venture market and ultimately create meaningful value creation opportunities for early-stage venture investors with available capital. Many companies that were funded just after the Dot-Com bust and following the financial crisis were very high-quality, offered VCs good entry value, and did well in the long run.

The Dot-Com Boom and Bust:

The years between 1995 and 2001 were like the Wild West, with similarities to the environment we have experienced over the past 5+ years. It was a founder’s market. There was more VC money to deploy than rounds/companies to fund. Competition between funds was stiff, and many Founders were consequently getting incredible terms and valuations. One of the key differences between then and now lies in the quality of the companies. During the Dot-Com era, the internet infrastructure and applications were being created from scratch, with raw start-ups raising large amounts of money with very high burn rates. Proof of legitimacy was scarce — companies didn’t need revenue, growth metrics, or even a product to get valuations in the hundreds of millions and even billions. For tech companies, valuations were sometimes based on a multiple of engineers/developers. Most recently, although the market has been super hot, the quality bar has been relatively high. Many of the unicorns we see in the news actually do have great products and revenue to prove their worth — just not quite to the level their valuations boast.

When the market collapsed in 2001, many founders and fund managers were torched as they were sitting on companies that had not yet found their footing, were burning lots of cash and had little to no cash reserves with zero prospects for fundraising. Many companies crashed to 0, while a few winners like Amazon, Google, Adobe, eBay, and Angie’s List ultimately rose to the top and still exist and thrive today.

The 2008 Recession:

While the financial crisis of 2008 did wreck havoc, it was different. Public equities plummeted, yet the private markets weathered the storm better. In their famous R.I.P. Good Times presentation in October 2008, Sequoia warned their portfolio companies to prepare for the worst. Following the mantra “Cash is King,” companies and VCs overall seemed to remember the doom and gloom of the Dot-Com collapse. Many understood the urgency and importance of “Survival of the Quickest” to preserve capital. Sequoia advised — make cuts, bolster balance sheets when possible, drive to cash flow positive, and spend every dollar as if it is your last.

During the Dot-Com bubble, many venture-backed companies pursued a “field of dreams” strategy of “build it, and they will come” with cash intensive capital needs. Yet, during the period leading up to and through the financial crisis, genuine innovation and market-need existed around significant macro investments into SaaS, cloud infrastructure, and mobile. Venture-backed companies — for the most part — were more capital efficient. Yes, Series A through C fundings dipped in 2008–2010, but Series Seed emerged for the first time during this period. As a result, new company formation grew, as did their funding, despite the decrease in post-seed capital.

Funds that had recently raised could deploy capital with less competition from their peers and at better company valuations, if not at a discount. The companies funded during this time were high-quality yet not overpriced and did well in the long run.

It was difficult for the fund managers that were raising in 2008–09 because many of their LP institutions had their allocations thrown off due to the public market collapse. These institutions — pensions, endowments, and the like — were committing a lot less to alternative investments and primarily to managers with whom they had existing relationships. Emerging managers raising their first funds especially had a difficult time. All in all, the 2008 recession was less destructive compared to the Dot-Com bust.

So What Does This Mean for 2022:

We anticipate that the upcoming recession (or maybe the one that has already begun) will be similar to that of 2008. Public markets will be heavily affected, which will influence fundraising patterns and valuations. LPs will continue to allocate to alternative investments via their long-time partners and forgo commitments to funds with limited track records. The best thing that funds can do to prepare is to ensure that they and their portfolio companies have enough dry powder to last through an extended downturn. With inflation in the mix, this economic crisis has a new beast that must be tamed which adds substantial uncertainty to how this crisis will evolve.

Undoubtedly, venture-backed companies should follow the mantra “cash is king” and buckle down, just as was the case in 2008. Industries will likely continue to pursue transformation through automation, so there remains good opportunities for venture investing. Companies will continue to be built, and those companies will need funding to grow. Furthermore, a refresh of valuations is well-overdue. While things may be dark for some time, it will likely be worthwhile to consider — “never let a good crisis go to waste.”

For exclusive insights into interesting deals in our thesis areas (vertical saas, generative AI, fintech), recommended reads from our team, and original thought leadership pieces, subscribe to our newsletter. Ideal for venture capitalists, startup founders, and industry experts.