Birth and Death

It’s probably a good time to discuss the recent regime change in markets.

In short: I’m cautiously optimistic.

It may sound strange to have a disposition anywhere near optimism during a significant market drawdown, but let me explain why.

We need cycles of startup birth and death to efficiently allocate human effort. If companies have the durability of government programs—persisting regardless of outcome—they will probably approach the same level of effectiveness. When capital is abundant, even to companies whose prospects of achieving long-term viability are slim, great people spend time on efforts that are ultimately likely to be fruitless. As expected, the past few years have been extremely difficult even for strong startups to hire.

Just as our bodies seem to work best when alternating between anabolic (abundance) and catabolic (scarcity) states¹, I believe the startup ecosystem to work best when there are occasional catabolic “cleanup” processes that free great people to focus on the most promising opportunities. Without cleanup processes, inertia tends to prevail. We’re in the middle of one of those cleanups right now and, though it is painful, I believe it will make for superior long-term results vs. the creeping inefficiency that comes from staying in an abundance state forever. Anecdotally, it’s already getting much easier for strong startups to hire.

The market has turned down the volume of speculation’s siren song. Like all professions, venture capital operates in an environment that reinforces specific behaviors. As you probably suspect, incentives in venture capital do not always align with long-term investment success.

In my opinion, one common hazard is to celebrate fast markups that accompany a portfolio company raising subsequent rounds of funding. In some cases a swiftly growing valuation happens because a team executes swimmingly, while in other cases the company is merely in a “hot” sector, which often happens in the wake of a high flying leader.² Fast markups are not intrinsically bad, but when investors seek to allocate to the companies most likely to get a fast markup alongside many others doing the same, a cohort of companies gains the emergent property of value being more dominated by capital flows than by fundamentals. 

Furthermore, the praise and promotions heaped upon investors following fast markups make for particularly strong psychological reinforcement.³ Once an investor has their first glimpse at the technicolor of “speculation”, the black and white of “investing” seems positively boring. Even though thoughtful fund managers recognize the issue with celebrating markups over progress in fundamentals, the practice is difficult to avoid given how few other metrics there are in judging investment skill in the near term.

The best answer I’ve seen to avoid this hazard is to maintain a culture of disciplined underwriting at each investment event that evaluates long-term outcomes under sane valuation metrics.⁴

I believe making money is safer (and more satisfying) than getting money. Some may have successfully traded out of speculative assets at the top⁵; however, most of us (myself included) are not smart enough to time the market. It’s far more reliable to invest in companies that have reasonable shots at improving their revenue, margins, and cash flow with hard work that’s largely in their control.

Speculation and investing look similar on the way up, but not the way down. The same attribute (appreciation via capital flows) that makes speculative assets so attractive on the way up becomes their demise on the way down. Such an asset that stops going up and to the right is “broken” and attracts little additional capital so that its clearing price declines precipitously as the asset is suddenly valued on fundamentals. Uh oh.

As Buffett famously said, “only when the tide goes out do you discover who has been swimming naked.” Now that later stage markets have begun to focus on the fundamentals of cash flow, margins, and the like, that same return to discipline trickled down initially into the growth stage venture and, now, into early stage venture markets. Reason is returning!

Many of the “hot” companies with eye-popping valuations are being re-evaluated under long-term-normal valuation criteria with a variety of results:

• Companies whose expenses matched their valuation (that is to say, extravagant) with little in the way of revenue and margin are in the process of imploding or being re-valued much lower.

• On the other hand, many wise founders took advantage of low cost of capital to pad their balance sheet while growing revenue, controlling expenses, and avoiding “toothy” deal terms. I suspect many of these companies will grow into and exceed their top-of-market valuations assigned in the last couple of years, with their shareholders being richly rewarded.

At the early stage, not dying is a prerequisite for success. For many companies in the middle of their growth trajectory—a modestly sized balance sheet with good prospective fundamentals but not yet having achieved repeatability and scalability—founders are finding themselves having to switch from a growth-focused strategy to a cash-preserving strategy while at the same time seeing the goalposts for their next round of funding move further away. The founders in this position who are likely to survive have been quickly decreasing expenses and raising additional capital⁶ so as to be able to weather the storm.

Planning for capital market storms is fraught with uncertainty—there is no way to tell ahead of time whether it will be a moderate squall or a once-in-a-century hurricane.  Facing the unpredictability of fundraising in the current environment, I like having a set of contingency plans that looks something like this:

• Plan A: raise a new round from a strong external lead immediately.

• Plan B: extend the previous round however possible to have the capital to hit long-term-normal⁷ metrics for the next funding round with significant margin of safety.

• Plan C: if unable to rase additional capital, execute to a breakeven, “default alive,”⁸ state.

While few companies need to execute a “Plan C” strategy, ensuring that it’s an option effectively guards against a terminal case of spendtoomuchinosis in an austere funding environment. 

It’s going to be a great time to build. After the dust settles, I believe we’ll be left with an extremely attractive environment for dedicated founders to execute. Here’s why:

• From death comes life—As mentioned above, as some companies fold or downsize, great people are freed up to work on new opportunities, making it easier to build world-class teams.

• Customers accelerate change in crisis—In times of plenty, both individuals and organizations can be slow to execute on necessary, but disruptive, changes. When large shocks occur, bold initiatives—e.g. automation, switching away from legacy vendors, moving processes from offline to online—become easier to stomach and even critical for survival. In these dynamic environments, nimble startups have the opportunity out-execute incumbents.

• Those who survive the downturn will be at scale with little competition in the recovery—by the time prosperity returns, the select founders who endured the pain to build repeatability, scalability, and strong fundamentals will be ready for rapid growth with few others at scale to challenge them.

At the same time, I believe it is also a great time for investors to back the force-of-nature founders who will weather the storm:

• Founders with fortitude will remain; tourists will go home—Given how much more difficult it is to raise capital, only founders who really care about what they’re doing will go through the gauntlet. Those who start companies lusting after quick riches will pursue other careers.

• Valuations are approaching sobriety—Even though early stage valuations have come down from their peak, some are still “expensive.” I believe it to be essential to avoid psychological anchoring⁹—comparing current valuations only to recent valuations—and make sure to underwrite against long-term-normal valuation metrics.

• Entry prices reflect today’s macro environment while exit prices reflect the future’s macro environment—While fundamentals of a given company are, in my opinion, the most important aspect of underwriting, it’s always nice when we get the tailwind of multiple expansion accompanying macro recoveries.

• Startup equity seems like an ideal bet in an inflationary environment—As I touched on in the last update, startups can typically raise prices in step with inflation rather easily while maintaining or improving contribution margin so long as they’re solving a problem that is important to their customers.

• Startup best practices are better than they’ve ever been—when we first started Lookout, it was very difficult to track down advice on how to build a fast growing technology business. Today, however, founders have so many best practices available via accelerators like Y Combinator, blogs, twitter, and early investors that I believe startup failure rates will be on a secular decline for some time to come.

• Technology is no longer a discrete industry; all industries are technology industries—while it’s tempting to think of “red ocean” sectors (e.g. crypto, consumer social, dev tools) as indicators of an oversaturated technology market with little white space, much of the economy still runs on legacy tools and processes that have not progressed in decades. I believe there will be immense opportunity to make the world more efficient, particularly in these sectors.

Of course, while all of the trends may line up for a great building and investing environment, I always try to keep in mind the words of Mike Moritz: “I invest in birds, not flocks.” 

It’s hard to be a venture index fund spreading capital evenly across the industry. Instead, I believe it’s a much more sound proposition to back founders who have the capability to build the industry defining companies of the next market cycle. These are the founders and businesses for which I’m cautiously optimistic.

1.  At the time of writing, I’m currently suffering through an intermittent fast and am eagerly awaiting my next meal in a few hours. Painful, yet long-term beneficial, I’m told.

2. The existence of a well-executing leader should *decrease* valuations of adjacent companies; however, when underwriting via analogy, the magic of cognitive bias often leads to the opposite. 

3. As it turns out “intermittent, variable-reward” schedules are extremely effective at reinforcing behavior in slot machines, online games, and capital allocation.

4. One piece of wisdom shared with me via an old hand in venture: it’s only by exercising restraint in times of abundance do you have longevity in this business.

5. Especially hard in illiquid private companies and not great for your reputation as a long-term investor.

6. In this circumstance, even “flat” or “down” rounds can be a wise long-term-optimal strategy to fund thoughtful execution in the midst of the downturn.

7. In the last few years, the venture world gave companies significant credit for future execution at every stage and that credit has quickly unwound.

8. “default dead” vs. “default alive” is a Y Combinator-ism that is especially relevant in times like these.

9. For the short-memoried frog, the water is never much hotter than it always was.