Company Building and Venture Investing in a Downturn

For the past year, news headlines have been dominated by the chatter of the “inevitable” correction/ recession predicted to end the longest-ever bull market the North American economy has experienced. The 12-year run has tested investor faith in the long term sustainability of recent growth levels. Some have cited the effects of US-China trade tensions, others an inverted yield curve. Most recently and acutely, the coronavirus outbreak has been a catalyst for these discussions as investors such as Sequoia warned of the epidemic showing “black swan” potential to upset the world economy, and the markets have plummeted to the lowest levels since 2008. We are officially in a bear market; how does this change the way we build and invest in companies?

The National Bureau of Economic Research (NBER) defines a recession as two consecutive quarters of real GDP declines[1]. The effects of a recession are often manifested by a contraction in public equity markets, reduced discretionary spending by consumers and business, and higher levels of unemployment[2]. While many (including Marc Andreessen) have argued that continued growth of the economy is the result of market efficiencies, it is essential for investors and entrepreneurs to explore and understand the implications of a recession on their investment thesis, portfolio construction, and company health moving forward. What is the impact of a downturn on venture capital as an asset class, and on the founders and companies we invest in? This post explores the effects of the 2008 recession on the venture and entrepreneurial space and extrapolates what a downturn could mean in the current context.

Impact

Most asset classes struggle during economic downturns, but the impact is far more nuanced than that. Private markets have proven resilient as the venture, private equity and startup lifecycle are long term, and as such, downturns tend to be more of a short term consideration. It is during these times that the perception of the illiquidity of private markets shifts from a disadvantage to a feature. That being said, certain effects will be felt more acutely, such as revenue decline, supply chain disruptions (in the case of the virus), and lengthened fundraising duration.

The situation currently being faced is unique however, in that it was not triggered by systemic forces but rather by a global public health crisis halting economic activity. This has unique implications that diverge from the effects of previous downturns, such as a stark decline in the supply side of most consumer goods, a workforce and a consumer base that can’t leave their homes, mass fear and a potentially shorter downturn cycle. Observable patterns that emerged during the 2008 recession can be used as a mitigation blueprint for how to think about conducting business in the current economic climate and how to best prepare for the coming months.

For start-ups, effects will be seen in the form of longer fundraising cycles with more stringent standards, an emphasis on cash/ profitability over strict growth, and decreased exits likely extending the venture lifecycle. For venture capital firms, the effects of a downturn will be absorbed in a delay, but will also include lengthened exits, difficulty closing funds, and compressed multiples. Downturns also present an opportunity for venture firms that are strategic in how they choose to invest in the market and support some of the uniquely successful companies that we have seen seeded during economic downturns at favourable entry valuations. Below are observable performance and macroeconomic trends during the last recession, and how they might be interpreted for a downturn today.

For startups:

1. Raising capital may become more difficult

Historically, startups have found it more challenging to raise capital during a recession. In the 2008 recession venture investment slowed, valuations declined and the average time between investments increased. With deal volume, IPOs and M&A activity decreasing, startups will feel the effects of tighter investment criteria, and a preference for efficiency and a path to profitability. Early-stage businesses will need to prepare risk mitigation plans and more conservative forecasts to present in fundraising conversations, and VCs will be focused on the road to sustainable profitability vs pure growth.

Raising in the middle and the end of the venture life cycle may also become more difficult as they are valued relative to public markets and as a result will see the most significant valuation reductions. Seed funding and earlier stage startups are furthest removed from the public markets, and thus the least likely to immediately be impacted. The good news is that although the number of rounds may not reach 2019 levels, however, the amount of dry powder raised in recent years will likely ensure that deployment continues despite the tighter criteria and rounds taking longer.

Overall, fundraising will take longer. Startups funded during the last downturn experienced longer periods between financings, startups seeded in 2008 on average took nearly 2.1 years to raise a second round, several months longer than the near 1.7-year average seen in startups that raised VC in 2010. [4] This indicates that startup companies took longer to hit the relevant metrics necessary to raise a follow-on round, confounded with a more difficult fundraising environment which led to a greater window between rounds.

VCs aren’t paid to sit on capital, so investors will continue to deploy capital regardless of the economic climate, even if the profile and deal frequency changes.

2. VC’s will be looking for a different profile of the company

The economic impacts of COVID and the potential following recession will impact the profile of companies that VCs will find attractive for investment. As sales funnels become less predictable and less efficient, companies with longer sales cycles or retail transactional businesses will face more of a challenge in closing deals given the pullback in consumer activity. In the short term, health tech, ed-tech, optimization tools, cloud and some business productivity tools will prosper, while companies in the travel and leisure, retail, manufacturing, ad-tech and those that broadly rely on consumers leaving their homes will suffer. In the longer term, a downturn will build on the sentiment of the attempted tech IPOs of 2019 wherein companies were effectively rejected by public markets due to a lack of a near or believable path to profitability.

In a downturn, we will likely see investors favouring companies with a more pragmatic path to profitability and strong business fundamentals over pure growth companies. Selective dealmaking, greater emphasis on a startup’s burn rate and a path to profitability will be important factors for startups. Unprofitable companies reliant on continued capital raising and high customer acquisition costs to maintain operations will find this climate more difficult to raise and grow.

3. Exits will slow

A downturn will lead to increased pressure on the end of the private startup lifecycle as IPOs and M&A activity slows, with public equity valuations likely to be the first to take a hit. In the previous two downturns, stock prices of top technology companies dropped on average by 37%[6]. As public valuations decline, private valuations follow, and the overall value of annual M&A transactions decreases. Following recessions, we can see that the M&A value decreased from $1,965M to $520.54M between 2000 and 2002, and the number of M&As decreased from 14,114 to 8,571 during the same period after the Dot-Com crash[6]. Post-2008, the pattern repeats as M&A annual value decreases by $337B, and transactions drop by over 2,200 M&A deals, suggesting that we can expect similar patterns in M&A activity if/ when a downturn occurs again[6].

As with M&A activity, the number of IPOs also dropped significantly after both the Dom Cot Crash and the 2008 downturn, with the value of exits dropping accordingly, though interestingly not proportionally. With a smaller exit value, startups face pressure to raise on smaller pre-money valuations if they are pursuing follow-on funding. As displayed below, after 2000, the number of IPOs dropped from 445 to 88, with the dollar value falling from $108.1B to $41B[6]. In 2008, the number of IPOs fell from 193 to 27 and the dollar value of IPOs fell over $20B[6]. Given the data points from 2000 and 2008 and a record number of exits in 2018, we can presume there will be fewer IPOs in the market after the next predicted recession. Companies will need to prepare for a longer time to exit, and the appropriate cash planning it will take to get there.

4. Downturns are a surprisingly fertile time for company building

The last recession was a surprisingly fertile era for company building, with startups Uber, Airbnb, Square, Slack, Dropbox, Glassdoor and other cornerstones of the unicorn club all founded during or in the immediate aftermath of the Global Financial Crisis of 2007–2009. Recessions have historically created room for disruption by empowering people and companies to find new revenue streams and challenge traditional business models. The 2008 recession was a notable period for software infrastructure and development tools. 2009 marked a record year both in terms of the number of companies raising over 100M and aggregate funding.

So what…

Cash is king. Founders should continue to build solid businesses that have a clear path to profitability and deeply understand the value they provide their customers, supported by a thorough understanding of cost drivers and scenario planning. In a downturn, companies must have a clear understanding of cash needs and be more conservative in runway forecasts. Companies should prepare for diminished access to capital (both amount and time) by striving to achieve break-even point or profitability sooner than they otherwise would and building earlier relationships with investors.

Founders should work with their investors to plan for longer fundraising cycles and shift operating plans and priorities as needed. Companies need to do a sensitivity analysis to understand the business impact under various scenarios and the implications for how they should respond. In order to most effectively understand costs and the levers of each, costs can be divided into categories such as headcount, essential and non-essential. Companies can consider non-essential segments of the business that are incurring costs and cut spending on areas “nice to have”. This is also a great time for re-negotiation of contracts from subscriptions to rent. Companies should also be very realistic about the value they offer customers and what percentage are at risk of churning, reducing revenue projections accordingly. Companies should remain focused on adding value for their customers, as that can eventually help them ride out tough economic conditions.

And what to do…

1. Conduct a scenario analysis: deeply understand cash flow for a range of business conditions. Explore if you can get to break even on your existing capital, and how your runway is affected by the change in market conditions. Cut costs to maximize runway and emphasize survivability. (Sequoia example below).
2. Understand your operational and cash levers and cut costs as needed: use the triggers built into the scenario analysis to develop a plan on how to manage costs: Discretionary spend, Wages, Sales pipeline
3. Assess your Go-To-Market and verticals: Is your current strategy reliant upon travel and leisure, retail, manufacturing or in-person gatherings? Consider how COVID and a recession will impact how you reach your target market, and whether there is a more attractive segment to go after given the circumstances.
4. Communicate with shareholders: Set expectations, clearly articulate needs and be forthcoming with information so your shareholders can better understand how to help.
5. Explore government programs, earlier fundraising and debt as needed: Understand how you will get cash well before you need cash.

For VCs

1. Difficulty closing funds:

As with startup companies, venture capital firms will also experience the effects of fewer or slower-moving funding sources. During the last recession, public equity selloff and the downturn in markets reduced the overall asset pool available for investment, with LPs becoming over-allocated to venture as value drops in other asset classes known as the “denominator effect”[4]. As a result, LPs reduced investment in VC funds, making it harder for VCs to raise new or subsequent funds. Following the Dot Com bubble in 2000, the number of venture capital funds dropped from 585 to 396 and again dropped from 443 to 388 after 2008. Similarly, capital raised by funds dropped from $88.4B to $49.9B after 2000, and $53.2B to $22.7B after 2008[6]. While this negatively impacted VCs during the last recession as LPs were over-allocated prior to the downturn, this time around LPs are not in this position (in some cases under-allocated) and thus should not experience as many issues with capital calls or new fund investments.

2. Lower multiples:

Another effect of a downturn is that multiples will compress. VCs will see smaller exits, and as a result, lower valuations and more flat or down rounds from one round to the next. The 2008 cohort also saw a considerably lower step-up of just 1.35x from the post-money valuation of its first round to the pre-money valuation of its follow-on round, compared to post-recession cohorts whose median valuation step-up hovered in the 1.6x-1.8x range[4].

Downward pressure on startup valuations and smaller round sizes These speculated effects are, in fact, illustrated in venture activity data throughout recession years. We showcase the data using trailing four-quarter activity to minimize underreporting in certain periods.

Interestingly, downturns have also historically impacted the venture community with a lag. The 2008 Recession officially began in December 2007 and persisted for 18 months through June 2009. The effects of the economic downturn were not fully reflected in venture markets until the second half of 2009, which continued to stagnate in 2010 until a recovery in 2011, showing that the impact was absorbed in a delay. Late-stage valuations bore the brunt of the impact on an absolute dollar basis, with the median falling from $36.8 million in four quarters ending 1Q 2008 to $28.6 million in 4Q 2010. Meanwhile, early-stage valuations saw the greatest decline on a percentage basis over the same period, falling 27.3% before recovering in the latter half of 2011.

3. Actually a great time to raise a fund…

While it may seem counterintuitive, the best performing vintages of private equity and venture capital funds tend to be those that are raised at the start and deploy capital at the bottom of a downturn and early stages of recovery. This is because these VCs benefit from lower multiple entry points lowered competition both in terms of investment and for the startup. This is contingent on the companies being fundamentally strong long term businesses with long term value (in contrast to some companies during the .com bust). On the flip side of this, VCs that raise and deploy in the lead up to a downturn tend to underperform. Downturns present an opportunistic raising and deployment opportunity for VCs but are also a concern for VCs raised in the past 3 years on frothy valuations if they have not chosen durable companies with long term value.

4. Changing Exit strategies

Near the end of the10 year investment period, VCs are expected to return the capital they initially invested ( hopefully more) to their LPs. This usually occurs through acquisition or IPO (less frequently). Relative to the last downturn, the current VC industry has more dry powder and is more liquid. Today’s VC ecosystem includes several nontraditional investors including a more robust secondaries market. This provides more liquidity opportunities for investors. As the time to go public has stretched, alternative exit strategies have gained traction and this trend will likely increase should there be a recession negatively impacting time to IPO and M&A.

So what…

For venture capitalist firms, the first step that should be taken is to come up with a plan to best support portfolio companies and a proactive strategy at a firm level. This includes taking steps to ensure that companies understand the implications of the current and continued downturn on their business and an operating plan to adapt in the best way possible. What companies are at risk? And what can be done to address this? Pay close attention to runway, burn rates, lengthened sales cycles, and potential customer attrition. Ensure companies are completing sensitivity analyses to understand these risks.

A change in economic climate also necessitates a different strategy. Think about how to be opportunistic in a shifting economic climate. As a firm, this is an important time to determine your strategy and the potential to be opportunistic with capital deployment. What is the optimal portfolio construction for the potential duration of a downturn, considering what will best support your companies and optimize for outsized fund returns? This could include shifting initial and follow on investment ratios to better support existing portfolio winners in a harsher fundraising climate or focusing on capturing the initial investment opportunities that present themselves in a situation with more decreased and more conservative capital deployment. As noted in Sequoia’s letter, the landscape may be changing but that too creates new opportunities for those who can see them.

As mentioned, the last recession was a surprisingly fertile era for company building, with startups Uber, Airbnb, Square, Slack, Dropbox, Glassdoor and others founded during the 2007–2009 period. A number of these companies, all with valuations of $1 billion or more, enabled the VCs that invested in them to achieve a 10x return in their portfolio. These are the VCs that found opportunity in a down market. In the words of Ben Graham, “Expect volatility, and profit from it.”

Downturns also enable active investors to have a deeper impact on the trajectory of the companies they invest in. Smaller round sizes, IPOs, and lower valuations will likely mean that startups will likely need to lean more on investor networks to support including: hiring top talent during an inconsistent job market, follow on capital and leveraging strong fundraising and business development networks.

What to do…

1. Talk to your portfolio and see where they are, how you can help. Make sure they’re thinking about burn rates and contingencies.
2. Triage and assess the exposure of the entire portfolio. Identify top risks based on runway and impact (to revenue or other material KPI).
3. Re-visit your reserve math and portfolio construction — your portfolio is likely going to need help, and you’ll want to support them and make new investments.
4. Communicate with LPs both through email updates and on a scheduled call to disclose any risk and discuss efforts.

In Summary

Venture capital along with company building is a long term game, wherein capital is largely locked in for a 10 year plus period. While downturns and a harsh economic climate make this process more difficult, there is an opportunity for those who are going after the right opportunities, are cash/ profitability minded and plan for the worst case. In the last downturn, startups found it more challenging to raise a round, and when they did it took several months longer and was at a lower valuation step up.

However, Global VC investors are sitting on nearly $189 billion of dry powder as of the end of June 2019, according to PitchBook data. This capital needs to be deployed, and thus even with a lengthened process and stricter criteria, great startups will continue to get funding and can take advantage of some of the unique opportunities of a downturn environment. Many of these factors may indicate some pressures often faced during a downturn might not be as acute this round as they have been in the past.

Some of the most successful and transformative companies of the past 10 years were also founded during a downturn. A disciplined approach to both company building and investing focused on honing in on and managing what you can control, reducing spend, anticipating more difficult capital raising and creating sensitivity forecasts will help prepare for the worst and win.

[1] https://www.nber.org/cycles/recessions_faq.html

[2] https://www.investopedia.com/insights/recession-what-does-it-mean-investors/

[3] https://news.crunchbase.com/news/the-most-recent-startup-investments-over-250-million-in-2019/

[4] PitchBook 2Q 2019 Analyst Note: Venture Capital in the Great Recession

[6] What Will Happen to Venture Capital When the Recession …. https://bowerycap.com/blog/insights/what-will-happen-to-venture-capital-when-the-recession-hits/