Venture Capital Investing in a Crisis?
Fears of a sustained economic contraction in Silicon Valley abound, whether from a viral vector, uncertainty surrounding the 2020 election, OPEC shenanigans, or the recurring fear that overinflated tech valuations are poised for a pullback. These fears are understandable — equity investors have lost more than $4 trillion in market capitalization from the mid-February market peak, and oil prices, the U.S. dollar, and emerging market currencies have all set new lows for the year.
Does this mean smart VCs should stop investing in great tech companies? Absolutely not. In fact, just the opposite is true. Long-term investment strategies should outlast a recession, and an economic contraction is when technology should shine. Technology innovations at their best translate to enhanced capabilities: the ability to do more with less and to provide superior functionality at a fraction of the cost. And truly innovative tech companies are able to reduce the pricetag on their products over time while actually increasing their own profit margins.
So tech investment should continue during an economic contraction with two important caveats that inform smart investments during all economic environments.
1) Price matters, now more than ever. Founders: We may like you; we may like your tech; we may like your company, and we may agree that you are building a valuable business. But if all that future value is already baked into your valuation, we can’t earn a return for our investors by investing in you. So we pass.
This is not a philosophical question, and we are not making a value judgment on your worthiness as a founder or doubting that your company is going to be worth a lot of money someday. Our analysis is simple: we are investors and the important question for any investor is not whether a company is valuable; the question is whether it is undervalued, because it is in the delta between the company’s priced valuation and its expected future value that an investor makes money. This is particularly the case if we anticipate you may experience an extra bump or two on your path to success due to an economic contraction or supply chain disruptions.
I have Peter Thiel to thank for drilling this important lesson into my head when I was starting out as a young VC at a fund that he had backed. He never asked me what the most successful companies were in the portfolio, which the highest-earners were, which was hitting its KPIs, or which companies were growing the fastest.
He would focus on just one question: which of our companies was the most undervalued and why. An approving nod and confirmation that mine was an “investible idea” meant that he agreed the company was undervalued and so it made sense to put more money to work. This interaction has punctuated almost all of our discussions, including our most recent one.
At the opposite end of the spectrum, we have all heard flashy VCs boast about the buzzy companies they are pouring money into: “Dude, X company is so hot right now; I would invest in X company at any price.” Really? That is not investing. That is buying a status symbol at an outrageously inflated price using other people’s money. Others believe they are investing in “safety” by buying into large, overpriced rounds of established, well-known startups, only to lose their shirts when these companies come under the disciplined scrutiny of public market investors.
Price matters. This is why so many of the recent tech IPOs were cause for celebration for the Seed and Series A investors and simultaneous tragedies for those who invested in the later pricier rounds.
As VCs we have the awesome responsibility of investing the precious capital of pension funds, charitable foundations and college endowments — the best among us also invest a hefty amount of our own capital alongside our investors. We have one job, which is to return a high multiple of that invested capital back to our investors. To do this, we need to find great companies and then fund them at valuations that are low enough, compared to the company’s anticipated future value, to give our investors a venture return.
High valuations eliminate that upside and ask us to take on the venture risk without the promise of a corresponding venture return, and so companies that are fully valued can be great companies but not good investments.
Asking a VC to give you a valuation that reflects 25x one-year forward revenues will be difficult for a smart VC to swallow during times of economic prosperity. It will be nearly impossible during an economic contraction.
2) Second, your product should be a “need to have” and not a “nice to have,” with significantly higher functionality and lower cost than the substitute incumbent and still be profitable for you. It is hard to get businesses and consumers to change their behavior — it is virtually impossible to get them to change their behavior for incremental improvements in functionality that come with a high pricetag during times of economic instability.
So Founders, before you try to raise a bunch of money from VCs, ask yourself whether your product’s functionality is at least 10 times better than the incumbent and is also 10 times cheaper. If you are selling to businesses, is the ROI (return on investment) your customer can expect by adopting your product 2x or 20x? If your answer is 2x, is there a market where you are a 20x? Because if you’re a 2x, you have probably already been lapped by the incumbent’s R&D department; you just don’t know it yet. But if you represent a 20x ROI to your customer base, you are a lot less likely to be fired when their own budgets contract.
