Is Now a Bad Time To Be a VC?
"We're Just People"
For almost any job there is a pool of people interested in "picking your brain on the industry." Whether you work in software development, law, investing, or mushroom foraging (probably). When I was getting into venture there were countless people who helped me way more than anyone could expect them to so I've always felt a strong obligation to pay it forward to folks looking to break into venture. I've even tried to capture my learnings throughout my career in what I affectionately refer to as "My Music."
Sometimes those conversations can be a little mind numbing. I think a lot about this "We're just people" scene from The Big Sick. I'll get on a call with someone and try to be overwhelmingly helpful (all any VC could want). "What can I do? I'll walk you through everything I would do. Inside baseball. What can I tell you?" And almost every time its (1) "what is your day-to-day like?" (2) "Is your firm hiring?" and (3) "well that's all the questions I have, but I really appreciate your time." I just want to reach through the zoom screen and shake them out of their conformity-induced Matrix mindset. "It's just you and me! Ask the real questions!"
But these days as the wall streets run red with blood from the mark downs and layoffs people have started softly asking the real question, "is now maybe not a great time to be a venture investor?" There is certainly a healthy debate about that but like anything the answer to the question gets more complex as you spend more time doing something. "It depends."
Generally my argument is that now is the best time in 5+ years to be a venture investor. A lot of people have made this point about how great companies are started in down markets. As a result if you're investing in companies getting started right now you'll see some great businesses get built up. I'm in that camp. At Contrary we focus primarily on pre-seed to Series C companies so there is plenty of opportunity for the companies we invest in to take advantage of a more flexible labor market.
All of this is true. There is some truth across several asset classes. This is also an interesting time to be working at a hedge fund because a lot of companies have gone public and then valuations have come down. Probably the only place that is really painful to be right now is investing in very late stage pre-IPO companies where you're sort of dangling with a lot of likely less valuable companies but not as clear a view on your pain as the public market folks have. But if you bucket that into "growth equity" and focus on venture investing as "companies that are likely 3+ years away from IPO? Then I think now is a great time to be in venture.
But what a lot of people skip over is the pain that is still likely to occur as we go from market excess to market constraints. It is true that a lot of great companies will get built right now but there are still quite a few venture-scale companies right now that have a lot of cash, high valuations, and potentially no clear path to product market fit.
Natural Selection Among Startups
I've written before about this idea that startups are exposed to some forces of natural selection that help to determine which companies will live and which will die:
"No one starts a business hoping that it dies. Founders pour their heart and soul into a company hoping to delight users and make a difference in the lives of customers. No one wants that thing to fail. But burying your head in the sand about mortality rates only increases the likelihood of falling victim to known causes of death."
The problem with the last few years is that a massive glut of capital has made it less likely that a company will fail because they can usually raise another round of funding if they have any indications of success. This isn't to say that no companies failed in the last few years but it was much more rare to see shutdowns, layoffs, etc.
The most common reason a startup fails is because of a lack of product-market fit. If you can't get product-market fit you can't grow revenue and if you can't grow revenue you can't make money. But when you have access to huge pools of VC dollars it can hide a multitude of sins, not the least of which is your lack of product-market fit.
As markets tighten and investors become more selective we'll likely see several phases of ripple effects through the startup ecosystem.
Phase 1: Quickly Running Out Of Money
We're already starting to see this kind of thing happen. Not every company that goes through a round of layoffs is dying by any means, but it’s acknowledgement that without adjusting course they very well could be. Year to date we've seen over 100 companies lay off 30K+ people across stages.
Lots of companies will be able to responsibly conduct lay offs, preserve cash, and be healthy companies going forward. Many will try desperately to make their runway last but will fail due to any number of issues (lack of product market fit, unsustainable unit economics, inability or unwillingness to fire fast enough). A generation of founders have grown up with very favorable VC market conditions but those conditions have changed pretty Fast.
Phase 2: Slowly Running Out of Money
Of those companies that are able to successfully curb their burn and preserve runway they'll likely be able to stretch their cash for 2+ years, which is ideal in this market environment. But if massive success for a startup was just a function of having enough time we would have a lot more big businesses. Sometimes no matter how good your team or how well thought out your idea or how well funded you are or how high quality your technology is there just is NOT enough appetite for it in the market.
Some companies have been slowly running out of money for years, so they may be shutting down right now and getting lumped in with the folks who ran out quickly. But one of the reasons that being an investor over the next few years will be difficult is that the company landscape is a bit of a minefield. There will be companies that show signs of life, they're signing new customers, hiring new talent, but the biggest question every investor will need to answer is whether this company is thriving? Or just surviving?
Some companies will cut burn, thrive, and build phenomenal businesses.
Some will make the painful transition to more stable cash-flow generating businesses. Gumroad is one examples of that and the CEO, Sahil Lavingia, laid out his transition from venture-backed to self-sustainability.
Some will become zombie startups that just keep slowly chugging along, but are not necessarily thriving. They're doing just enough to keep the lights on.
But one way or another every company is faced with the inevitable punch-to-the-face that is product-market fit. No matter how hard you work and build and hire if you don't find product-market fit you are running out of cash, one way or another.
Phase 3: Consolidation & Soft-Landings
Once those companies who are slowly running out of money realize they're just not finding product market fit they'll start to look for a soft landing as part of an acquisition. Right now is a very interesting time for people and companies who are good at M&A. Consolidation is likely to pick up. For the last few years the amount of VC cash available could sustain 5 or 6 decent sized players but will now start to pile into one.
Don't get me wrong. Tech M&A has already been hitting record highs. But that was often a different kind of M&A. The first half of 2021 saw $600B+ of acquisitions but a lot of that was big players flush with cash buying slightly less big players (Microsoft acquiring Nuance for ~$20B) or big SPACs that effectively "count" as M&A (like Grab's SPAC that went out at $40B and quickly tumbled to ~$9B).
The kind of consolidation I'm talking about is when smaller companies start to get snatched up more frequently. These are companies that have built some unique technology or assembled a unique team so they're getting bought for the pieces. Not because they could be a standalone business unit.
Phase 4: Startup Death
Again, this isn't to say that startups haven't shutdown for the last few years. But as a lot more companies are forced to contend with the fact they don't have product-market fit they'll look to M&A as their soft-landing.
But here's the struggle. A $1B valuation morphed from the stuff of legend to literally the average for later stage rounds. With a price tag like that acquisitions become much more difficult, at least ones where employees or investors will make much money.
For companies that have built undifferentiated tech they'll struggle to get acquired because there are ways companies can build those products without shelling out cash to buy them.
For companies that haven't maintained very high hiring bar they'll struggle to get acqui-hired because larger companies will worry about the potential impact to their internal cultures.
What Does This Mean For Venture?
Who knows how the market will change, whether we're nearing a bottom, or whether we're just getting started. But this potential minefield of companies struggling to survive without as much available cash will make it tricky for venture investors.
The best companies will do fine and even continue to raise additional capital. If anything those companies may continue to see somewhat inflated valuations as investors fight to pile into the "known knowns."
Beyond those companies that are checking every box there will be a newfound interest in deeper due diligence to make sure companies are actually thriving vs. just surviving.
That being said, right now is certainly a difficult time if you have billions of dollars to deploy. For firms that are able to take much more concentrated strategies in the very best companies that's one thing. But once you're actively deploying $3B+ you need to be able to deploy capital much more quickly. And that's tough in a minefield.
I think one of the only exceptions to this are firms like Insight who, even though they just raised a $20B fund, have a very different DNA as a firm. Not only are they investing in "high flying" companies they also have a lot of experience in large buyouts and working with more stable cash-flow focused companies.
Even if you are a high-flyer that has taken money from Insight as a high-flying company if you want to go roll-up your two or three closest competitors Insight has a lot more experience helping with that kind of thing than any traditional venture firm, even the large ones.
So, is now a bad time to be a venture investor? No. There are phenomenal businesses being built right now that will have a massive impact on the way we live our lives and do our work. But in a lot of ways it’s been easier to be a venture investor for the last few years because almost any investment you make will likely get marked up down the road. So it is going to be less easy to be a VC. But that's what makes it fun. You actually have to do the work.