Is Winter Coming?
For those of you who have been watching the public markets with trepidation, wondering what it might mean for the VC market, I thought I’d share some personal thoughts.
I’ve been amazed at how quick and deep this public market downturn has been. While the indices and big names aren’t down much (the S&P 500, for instance, is only down 10–11%), most of the higher growth, more speculative “venture-like” public companies are down 50–80%+. For example:
- Robinhood is down 84% from peak
- Peloton is down 83%
- Zoom is down 73%
- Upstart (who acquired our portco, Prodigy) is down 80%
For big segments of the market, this is a crash that’s almost comparable to the dot com bust (and might be fully equivalent by the time this is over). Amazon, as one point of comparison, crashed >90% from peak to trough in that era.
In our corner of the world, the big question on everyone’s minds is: how will it impact the VC market?
Many VCs on Twitter are proclaiming that valuations are just as high as ever — and that may be accurate right now. However, I don’t believe it’s going to last for a few reasons, which all have to do with the venture market lagging the public markets:
- The round sizes and valuations you read on Techcrunch are 3–6 months old (or older). Most companies wait a while to announce their rounds, often using the news as an advertisement for the next round.
- Same thing for the markups you’re seeing in your AngelList portfolio — they are 90 days old (AngelList delays the LP reporting by 90 days after rounds close).
- The cycle of fundraising and capital deployment for VC funds takes time. Many VCs raised huge new funds over the last year or two, and they have to deploy that capital. So there are likely still big rounds at high valuations getting done, from funds that were raised while the market was hot, and have to be deployed (or the VCs don’t get paid).
For all these reasons — both reporting and the deployment cycle times, the VC market has a tendency to lag the rest of the market. But it usually catches up, in time, and I expect that will happen again this time around.
One factor that will drive a capital pullback is that most institutional LPs construct their portfolios with weightings to a variety of asset classes, placing (for example) 40% in public equities, 30% in fixed income, 20% in private equity and venture capital, etc. As their other asset classes decline as a % of the whole, their VC allocation will balloon to an excessive % — which means they will have to stop allocating to VC so they can rebuild the asset classes that are underweight. Angel Investors behave similarly — usually making a decision to allocate X% of their portfolio to this asset class.
A second factor that will drive lower valuations across the venture market is that each stage of investors makes valuation decisions based on a probabilistic expectation about what the next round valuation is likely to be. The pre-IPO investors invest for a markup into the IPO, the Series D investor wants a certain markup into the Series E, and all the way down. We, for instance, typically invest with the expectation that if things go right, we will get a 2–3x markup into the next round within 1–2 years. The pre-IPO investors are already underwater (on average) on their investments that IPO’d, which means that they will begin adjusting their entry valuations. The moment those shift, the round before that will correct down — and the impact will cascade all the way back down to us at seed. Once everyone accepts that this is coming, the whole stack will correct relatively quickly.
So what does it mean for us?
I’ll segment my thoughts into two buckets: 1) existing portfolio, and 2) new investments.
For the existing portfolio, yes — things are likely to get tighter, and I won’t be surprised to see some carnage in the next 2 years. But here’s the thing: we invest in startups with a 10+ year time horizon for each investment. When you plan to hold for 10 years, it’s basically guaranteed that you’ll see a bear market in that time (and maybe 2). It’s only a question of when.
The bear markets that happen will, unfortunately, accelerate the demise of the weaker companies. With capital harder to come by, the struggling companies will have a harder time raising, some will have to do down rounds, and some will fold. Flat rounds will be worth celebrating.
I do feel fortunate that a lot of our stronger companies have recently raised lots of money, and probably won’t need to raise again for a while. If these companies can get their burns under control and navigate to profitability — they are going to be just fine.
And for the very top companies in our portfolio, the downturn may (counterintuitively) have almost no impact. For example, one of our strongest companies, that is now worth a large percentage of our overall portfolio, is doubling its revenue every 1–2 months. If they recently did a round that values them on the high side (such as 4–5x the valuation they might get in a bear market), and they keep growing at this rate — then they will be “correctly” valued again within a matter of months. The range of valuations that can be applied, even at the extremes of market sentiment, pales in comparison to the rate at which the fastest-growing companies compound.
As you know, venture investing follows a power-law curve, where the best investments tend to end up worth more than everything else combined and return the portfolio many times over. Because of this, all that matters for our financial returns is the top few investments we make.
So putting this all together: considering that our very strongest companies were probably going to carry our portfolio regardless of what the market does, our weakest ones will have a negligible impact on our overall returns, *and* we have no plans to exit any of these positions any time soon — I’m of the opinion that this market action is going to have almost no meaningful long-term impact on our existing portfolio. Indeed, bear markets are a guaranteed part of the journey of most successful startups.
Shifting gears — for new investing, things are about to get exciting for us. At last, valuations are likely to get more reasonable again, and perhaps more importantly: we will actually get access to more of the best companies. Bear markets are *always* the best time to be making new investments.
Looking back, we had a mini bear market in 2020. I even wrote about it in a post about COVID in February 2020 (I didn’t get everything right, but I did encourage everyone to keep investing in startups through the downturn). We kept investing hard through that period of fear and uncertainty (when many investors pulled back), and guess what: 2020 is our best vintage to date, already valued at ~6x capital invested (assuming rounds underway close as expected).
While it will likely be scary again to invest through 2022, I have no doubt that in time, 2022 will similarly prove to be a prime vintage.
I feel grateful to our Rolling Fund LPs, the vast majority of whom have made long-duration commitments with us. These steady, long-term commitments will allow us to keep investing through the downturn, and thereby enable us to reward them with great returns. If you’re not yet part of our Rolling Fund and would like to be — for what I believe will be a prime year of investment opportunities — you can find it HERE.
All the best,
Peter Livingston
