Winter is Actually Here (Again)- What It Means for VCs and Startups

Ever since the stock market realized that gravity was a real thing, people have been asking me, often multiple times a day, what this may mean for the world of venture capital and startups.  And because this is my third rodeo (I was in venture capital during the 2000 stock market mini-implosion  (aka the Dot Com Bubble) and the 2008 meltdown misery as well), I think I might be able to use my pattern recognition powers to actually answer the question!

As an aside, I’ve been saying there is a digital health bubble for several years, only to be proven temporarily wrong.  I wasn’t actually wrong; I was just off by a few years   But unfortunately, the bubble that we are currently riding southward has hit not just healthcare, but all sectors.  We are basically seeing a major market correction, fueled not just by over-valued companies, but amplified by world events of major proportions.  It is a confluence of negative events that experienced business experts might call a “shit-show,” as the saying goes.  Yikes.

When this happens, and by “this” I mean when the stock market desperately seeks to return to sea level, there is a clear impact on the venture capital and startup world.  These things are inexorably linked, despite them seeming somewhat distant from each other on a typical day at the office.  The stock market decline is the leading indicator, the venture capital downturn the lagging one, typically following the stock market’s downward spiral by 3-6 months.  The reasons for this are many-fold.  First, when there is no IPO market, private companies can’t go public and thus exits are suppressed.  Because M&A becomes the only option for exit, buyers of venture-backed companies have a lot of leverage, and they use it to lowball acquisition offer prices.  Notably, these buyers are also struggling with their own stock price dramas and often pull back on investment and M&A activity, declining to acquire companies that will further dilute their earnings per share (as most startup acquisitions do).  I would predict that we will see a meaningful decline in corporate venture capital by the end of the year, if not sooner, since large public companies with venture investment programs tend to focus on their internal knitting during times like these.

Because portfolio companies can’t exit in the positive sense, they need to exist (aka, burn cash) much longer than they and their venture backers had planned.  For those venture funds with tons of cash on hand at the time of the downturn, it’s party time.  These firms have the money to back their best companies through the dark times and then tend to protect them and keep them close, letting few new investors in.  This hoarding of the best deals can negatively impact interesting deal flow for the rest of the funds out there who are also looking for the needle in a haystack opportunity.

Additionally, and this is key, well-funded venture funds have the power to drive down valuations of other companies in times like these.  They do this by leading “down rounds” where they invest in great companies at lower valuations than those companies previously garnered.  This means that the venture funds who don’t have the capital to “pay to play” get seriously damaged, because the term sheets often feature clauses that wipe out the value of previous investors’ holdings if they can’t continue to invest.  Often, these early-stage investors have to switch from offense to defense, playing a game of Sophie’s Choice where they use their precious reserves to support the few most likely winners in their portfolio.  This is why it’s very tough for micro-venture funds (those under $50 million in a fund) to thrive when bad times come.  They don’t have enough cash reserves to stave off the predators.  Every venture fund will tell you they never do this predatory stuff.  And every venture fund will be not entirely truthful.  Never forget that the VC job description is to take a pile of money and make it into a bigger pile of money.  “Play nice” is not part of the job description of institutional venture funds.  Some genuinely try to play nice with other investors and with entrepreneurs, but the siren song of goosing returns is too simply too loud to resist over a multiple-year downturn.

This whole phenomenon means that less-well funded companies (or companies with less resourced investors) have to fend for themselves; and that can perpetuate a kind of ugly downward spiral, since those companies become less worried about what happens if their “old” investors can’t fund the company and they need to accept lower valuations to survive.   And that is the entrepreneur’s implicit job description – keep it going, keep it growing, keep it alive.  Everyone gets very confused about when to put on their Board of Directors hat (which means you have to look out for ALL shareholders equally) or whether they should don their “I’m in it for my team” hat.  Lawyers make out like bandits during these times, just on the hours they can charge for explaining the meaning of fiduciary duty in laymen terms.

Major market downturns can cause small venture funds to cease operating, as previously noted, but many larger venture funds who did not use sensible valuation discipline also struggle.  We are already seeing some of this as Softbank and Tiger Global have watched the market erase literally billions of dollars of book value.  I hate that when that happens.  These two firms are massive and may be fine in the end, but some large funds watching their portfolio company valuations circle the drain will not be so lucky.  It’s hard to raise a new fund when your last one couldn’t put positive numbers on the board because the companies couldn’t survive the downturn or you got washed out of subsequent rounds.  It’s in these moments that VCs realize how important basic investing fundamentals really are.  It also drives venture investors to remember that due diligence is a thing.  Lots of investors let that discipline get a little sloppy during the go-go times, following into over-priced deals out of a sense of FOMO and forgetting that the music sometimes does, in fact, stop.

In these moments, venture funds with lots of capital also get to take advantage of the opportunity to invest in much later stage (aka, de-risked) deals at much lower valuations.  Thus, they tend to cycle away from the earliest stage companies. Seed stage and A round companies with triple digit valuations become unicorns in the actual sense of the word – mythical and unseen except in the décor of a 5-year-old girl’s bedroom.  It would not be surprising to see the meter move precipitously away from the earliest stage deals in favor of later stage companies at “bargain” prices.  It’s a glorious moment for venture funds with lots of fresh powder, as they get to buy low and, best of all, sell high as the market comes back, as it inevitably does, over the next 5-10 years, which is about the right timeline for most of the funds’ investment horizon.

Angel investors also tend to run for the hills during these downturns.  If they have a lot of their net worth (former net worth?) tied to the stock market or to illiquid venture investments, they tend to get a lot more conservative and tuck their checkbooks back into their pockets.  It’s easy to magnanimously write checks to cool startups when the money tap is flowing.  It’s hard to do so when the drain is working faster than the tap.

And in case you weren’t anxious enough by now, entrepreneurs have some other trials to face in tough markets.  Sometimes they are forced to sell their companies early because that is the only path to survival.  Often, they need to lay people off and sometimes they even have to cut costs to culture-of-poverty levels – back to one-ply toilet paper and time to return the kombucha-on-tap machine to its previous owner.  Late-stage company entrepreneurs who have yet to learn how to spell EBITDA can really struggle.  Investors suddenly switch channels from GROW GROW GROW to SURVIVE SURVIVE SURVIVE, and want management teams to turn on this dime (Wait, did you say dime? Save it!) by, say, 3 o’clock this afternoon.

A weird bright side:  as both large companies and startups are forced to lay off the people they have struggled so hard to hire, it gets easier for startup companies to find the people they have been struggling to hire, assuming they now have the money to execute on that plan.  Nothing like a little irony.

But don’t despair entrepreneurs!  The truth of the matter is that a large number of the world’s best companies were founded during economic downturns.  Check out this list of companies founded during dark financial times:  FedEx, Trader Joe’s, Hyatt, Disney, Microsoft.  Notably, even Google and Salesforce were founded right before the dot.com bubble went boom.  And that’s just the household names.   Surviving and thriving during the tough times means you are lean and mean when the good times roll again.  In other words, if you can put your head down and just keep moving forward, choosing efficient growth over buying markets with bags of cash, the sun will, in fact, come out tomorrow.

Anyway, from now on I’m just going to refer people to this article when they call for my two cents on the future.  My crystal ball is suspiciously suspended in a glass of bourbon right now, so who knows, maybe I’ll be way off – would not be the first time.  But if I’m right and Winter is (finally) Here, batten down the hatches, entrepreneurs, and aim for being there when Spring comes.