What Should Fund Managers and Founders Expect When Winter Comes
I was in undergrad for the last recession so I wanted to understand what happened and what to expect for the next one.
Indicators of a Coming Recession
The US economy is in its 10th consecutive year of a bull market. The S&P 500 is reaching record highs and is up over 300% since a decade ago. We traditionally experience a bear market, a 20+% drop in the stock market, every 8 years on average so we are statistically overdue for a downturn.
The recent yield curve inversion, historically a reliable early predictor of recessions, also suggests a downturn could be coming. An inverted yield curve has preceded every recession since the 1950s. The recession typically hits hardest about 22 months after, although the downturns can come as far out as 34 months after.
Let’s look at why this matters.
Vintage Importance for VCs
Vintage year, the year a fund makes its first investment, is a strong indicator of performance for venture funds. Even the top tier funds have bad vintages when the market doesn’t cooperate.
Pooled data from Cambridge Associates shows the aggregate results from 1,600 venture funds. Check out the single-digit returns of the top quartile funds around the 2000s.
Recent data released from the University of California shows that even Sequoia has bad vintages.
The Last Recession
A recession is generally considered two consecutive quarters of negative GDP growth. The last recession in the US was the “Great Recession”, which was a 17-month span from October 9, 2007 to March 9, 2009 where the S&P 500 lost ~50% of its value.
The immediate impact of the downturn is that it is difficult/impossible for later-stage startups to go public.
Early-stage startups are not as strongly impacted by public market downturns as later-stage startups. Early-stage companies are looking at exiting in 5 to 7 years so public market downturns today are less of a concern.
Early-Stage Deal Activity
Early-stage VC seems to absorb the effects of the recession with a significant lag. Deal count increased slightly from the start of the recession before decreasing as the recession progressed.
Early-Stage Startup Valuations
The effects of the economic downturn were not fully reflected in venture markets until Q3 2009, almost two years after the recession began. Early-stage valuations fell 27% during this time before recovering in the second half of 2011.
The delayed effect makes sense when you think through the supply side of the market. VCs have significant “dry powder” when a recession begins and need to deploy that capital in the next few years regardless of the macroeconomic conditions. The decrease in VC fund supply doesn’t come until later as LPs start to rebalance their portfolios.
Some of the response delay can be attributed to a reporting delay. GDP advance numbers come out roughly a quarter after they happen so you are looking at finding out you are in a recession 8-9 months after the recession has technically begun.
Anecdotally VCs also get more conservative during the recession and spend more time identifying teams that have a track record of success, experience operating in cash-constrained environments, and business models with a focus on profitability (sorry WeWork!) that do not require large amounts of cash to achieve break-even.
Angel and pre-seed valuations counter-intuitively went up for the first 1.5 years after the recession began.
Longer Period Between Fundraising
Startups funded in the recession take longer between financings, which reflects the more difficult fundraising environment. Startups funded in 2008 took 2.1 years on average to raise a second round while startups funded in 2010 took 1.7 years on average.
Lower Valuation Step-ups
Startups funded during the recession also saw lower step-ups in valuations between their first and second rounds. 2008 startups only saw a 1.35x median step-up in pre-money valuations in their follow-on rounds while 2010 startups saw a 1.7x step-up.
More Bankruptcies
Startups funded in the recession also saw more bankruptcies in their second-round outcomes than the startups that came before them. 14% of 2008 startups went bankrupt while only 6% of 2005 startups did. About 14% of 2010 startups also went bankrupt so this may be a larger trend outside of the recession.
Successes From Last Recession
VC is a business of outliers and those outliers are still being founded during the recession. Although it seems at a lower rate. Quite a bit fewer unicorns were founded in 2008, compared to 2007, 2009, or 2010. 2008 was the year Airbnb began though.
2007:
- Twilio (public; $14.8B, Oct 2019)
- Flipkart (acquired by Walmart for $16B in August 2018)
- Dropbox (public; $7.8B, Oct 2019)
- MongoDB (public; $7B, Oct 2019)
- Github (acquired by Microsoft for $7.5B in Oct 2018)
- Glassdoor (acquired by Recruit Holdings for $1.2B in June 2018)
- Tumblr (acquired by Yahoo! for $1.1B in June 2013)
2008:
- Airbnb (private; $38B, 2019)
- Pinterest (public; $14B, Oct 2019)
- Cloudera (public; $2.5B, Oct 2019)
- Beats (acquired by Apple for $3B in May 2014)
- Yammer (acquired by Microsoft for $1.2B in July 2012)
2009:
- Uber (public; $54.6B, Oct 2019)
- Square (public; $26.9B, Oct 2019)
- Slack (public; $12.5B, Oct 2019)
- Nutanix (public; $4.9B, Oct 2019)
VC Fund Raising
Most institutional investors have set portfolio allocations for “alternative assets” like venture capital. When the value of their public market equities falls, LPs become overweighted in venture capital and hold off on additional investments in VC to rebalance. This makes raising a fund harder in downturns.
VC Approach For Upcoming Recession
- Timing —Timing markets is effectively impossible so LPs don’t fault VCs for bad market timing. Fund managers get compared to other funds of the same vintage. Even the best firms have bad vintages. If you could time the markets, you would ideally raise a fund pre-recession (it’s much harder to raise after), deploy it when startup valuations fall, and sell the companies off as the economy is booming. Classic buy low, sell high investing.
- Flight to quality — Invest in pure tech, high margin businesses in recession-resistant industries with experienced founding teams that have operated in high growth, cash-constrained environments. Vertical-businesses that require significant capital infusions will likely struggle more than pure tech plays.
- Invest in winners — The winner-take-all market trend increases in recessions as weaker companies struggle. Leaders can weather the recession and acquire failing competitors.
- Time diversification — Deployment time for venture capital funds has been compressed recently. It used to be 3-4 years and now it is closer to 12-18 months. There is value in taking longer and making sure you are able to catch a lull in a cycle. Alternatively, you may want to deploy quickly in a bull market and get the following fund raised before the next recession.
Founder Approach For Upcoming Recession
- Be default alive - The recession will weed out the startups with unsustainable business models and short runways. Avoid this fate by being default alive, meaning “assuming expenses remain constant and revenue growth is what it has been over the last several months, do [you] make it to profitability on the money [you] have left". This preserves optionally. You can raise more and be ambitious, but you don’t have to. Either way, the company survives.
- Raise more - Stock your bank accounts with more than the usual runway. If you were targeting 12-18 months, target 24+ months. This gives you more time to figure out a way to be “default alive” or at least weather a downturn.
- Be lean - Besides having a sustainable business model, being lean is the best way to survive. Hiring too fast is a great way to burn cash and move into the default dead territory. Wait until it is clear you have a product that people really want before pushing the gas on hiring.
"The winters are hard but the Starks [startups] will endure. We always have."
-Ned Stark