#VCs and #startups are dealing with the reality that today’s environment is brutal compared to what it’s been like over the past few years.
The reason for the abrupt shift is that Darwin went on vacation for a few years but has finally returned.
This changes EVERYTHING! 🧵👇
It’s undeniable that the VC and startups ecosystems feel different in 2022 than they did in 2020 and 2021.
For years, money was flowing freely from LPs to VCs and from VCs to startups. Many startups went public or were sold and the returned liquidity added fuel to the fire.
But today’s markets aren’t behaving like they did in recent years.
Worsening macro conditions short circuited a long bull run and Investors are shifting from risk-on to risk-off mode. Public stocks adjusted first but the ripple effect is starting to impact the private markets.
What follows is a narrative about the Acceleration Phase (2020 + 2021), the Correction Phase (2022) and the New Normal Phase (Now and Beyond) in the private markets.
The narrative focuses on the three main participants: Startups, VCs and LPs.
And the narrative is dizzying.
Acceleration Phase (2020 + 2021)
VCs deployed capital at a breakneck pace and raised bigger and bigger funds to feed their machines.
VCs found it easy to raise from LPs because they were flush with capital given the performance of the markets for more than a decade.
Capital was cheap and abundant which led to a universal “grow as fast as you can” mentality.
Founders and Boards suffered from mono-variable-itis.
All they cared about was top line growth which led to “bigger and faster” at the expense of “capital efficient and sustainable”.
Outcomes were multiples of historical norms which changed the calculus of investing. This “truth” rippled from late to early stage quickly.
Valuations collapsed to simple division. A startup would want $X and was willing to accept dilution of Y% which implied a valuation of X/Y.
Since Founders only give up when they run out of cash, the abundant capital had a second order effect of preventing failures and fueling good, marginal and bad businesses alike.
As long as a business found a way to grow it was able to attract funding.
VCs were underwriting to the false signal of the next round being an up round vs. the de-risking of a startup’s business model.
Back-to-back rounds were happening at increased valuations and increased speed with very little having been proven in-between.
And it was working.
The number and size of IPOs eclipsed anything seen in recent history.
Acquisitions happened at multiples that defied gravity.
And half-baked businesses SPACed to ensure that Founders and Investors didn’t miss out on the gravy train.
Darwin was on vacation.
The Correction Phase (2022)
The first half of 2022 was marred by a worsening macro environment.
Inflation concerns drove aggressive tightening by the Fed and the effects of the Russia/Ukraine war were felt globally.
The economy struggled and the S&P 500 was down 20%+.
In the public markets, the darlings of the past few years were in complete free fall.
High growth tech stocks were down more than 50% and many as much as 85%.
Recent IPOs suffered the same fate and companies that SPACed performed even worse.
The days of cheap and abundant money were gone.
The days of unprofitable high growth tech stocks being well received by the public markets were gone.
The days of all asset allocation strategies producing solid returns were gone.
Darwin had returned from vacation.
The impact in the private markets was sudden and dramatic. There was plenty of dry powder in the system but much of it was frozen.
Exit valuations were no longer solely based on revenue. Most startups were overvalued and misconfigured to be attractive in this new environment.
Investors quickly modified the formulas that governed what a company was “worth”. Capital efficiency and profitability were suddenly very important.
With capital availability no longer a certainty, Founders had no choice but to refactor how their businesses were configured.
It was as-if a global playbook had been issued to the entire startup ecosystem that consisted of RIFs to lower burn, reduced marketing spend and growth rates to improve paybacks, and holistic operating plans that made current cash last twice as long.
VCs ranked their companies and prioritized follow-ons in their “great” companies to prevent them from being in-market anytime soon.
Raising in 2022 was considered a fool’s errand and raising in 2023 was to be avoided. Insider-led rounds made this possible.
Insider rounds went from being a historical signal of weakness to a real signal of strength.
Flat rounds and extensions went from the exception to the rule.
Convertible notes became a popular way to avoid pricing companies.
And structure started returning to term sheets.
But some startups had to raise from new investors in 2022.
They were companies that couldn’t find ways to make their cash last much longer AND weren’t in the top 25% of their existing Investors’ portfolios.
The result was a tangible reduction in quality for in-market deals.
VCs reacted accordingly and slowed their pace of investing.
Funding in Q3 2022 was $81B, down over 50% from Q3 2021 and Q4 could be worse.
This dramatic pullback was market driven but also a second order effect of the LP community dealing with “The Denominator Effect”.
The Denominator Effect occurs when the value of one portion of a LP’s portfolio decreases drastically and pulls down its overall value.
Definitionally, any segments which did not decrease in value at the same rate end up representing a larger percent of the overall pie.
LPs develop strategies that bucket investment opportunities into asset classes and then allocate a certain percentage of their portfolio to each bucket.
The historical and projected performance of each asset class impacts allocations but balance matters to LPs more.
With public equities down massively in 2022, LPs definitionally have less money to deploy and they need to re-balance their portfolios.
This will come by reducing VC exposure which in turn will directly impact the startup ecosystem.
Which brings us to today:
The New Normal Phase (Now and Beyond)
Since the VC asset class is illiquid, LPs can only reduce exposure through new allocation decisions.
Rationalizing which VCs to shed will be painful but necessary for LPs in 2023 because there’s more demand from VCs than supply from LPs.
The Cambrian explosion of new VCs in recent years was fueled by a relaxing of LPs’ historical criteria but LPs are returning to their roots given the uncertain environment.
The truth is that Darwin favors results over promises and newer VCs might struggle to raise capital.
Darwin favors VC firms with differentiated strategies, long histories of realized top quartile returns and experienced investors who have worked together through cycles.
Darwin makes survival difficult for VC firms with generic strategies, unrealized returns or unproven teams.
If step one of Darwin undoing the damage created while he was on vacation is to preferentially make new capital available to proven VCs, step two is for VCs to internalize that their dry powder is a precious commodity.
VCs are in the business of investing capital, but given the “New Normal”, VCs will aim to deploy their dry powder very thoughtfully.
The bar will be raised on the quality and progress of startups being funded. VCs will value results more and narrative less. Proof will matter.
Step three of Darwin’s return is for Founders to internalize that how startups were built in the recent bull market has to be contextualized.
Simply put, the fundamentals of how to fund, build and scale startups efficiently needs to be relearned.
Disciplined Founders will procure and allocate assets efficiently.
Disciplined Founders will maximize learnings and scale costs carefully.
Disciplined Founders will be ambitious while de-risking their businesses in stages.
Disciplined Founders will thrive in this new world.
The final step of Darwin’s return is for marginal businesses to be starved of capital.
Without new capital, marginal businesses will have to improve their current operating plans (if they can), sell to a bigger player (if they can), or shut their doors for good.
The New Normal should prove to be a perfectly good environment for LPs, VCs and Startups to thrive as long as they acquire the taste for disciplined investing behaviors.
But not everyone will learn to acquire the taste which will force Natural Selection to do what it does best.
I hope you’ve found this thread informative and interesting.
If so, a like and a re-tweet of the initial post in the thread would be appreciated!
Founders know that building a successful #startup hinges on being able to adapt quickly.
A master plan can focus and guide a team, but when it stops working it’s important to quickly improvise a “Plan B”.
And do you know who does this extraordinarily well? Jazz musicians. 🧵👇
If startups were a style of music, it’s very clear that they most closely represent Jazz.
Founders will tell you that what happens day-to-day has an element of improvisation and spontaneity that’s a reaction to what they’re experiencing in the moment.
Decisions are typically made with incredible speed and adjustments are made equally fast.
A Founder needs to be hyper-alert to signals and feedback coming from all directions and as a result their plans and teams need to be fluid and malleable.
The current spike in #inflation has lasted longer and is more challenging to manage than expected.
The Fed is combatting inflation with increases in interest rates and the equity markets aren’t happy.
Why have equities sold off and when does the recovery begin? 🧵👇
Inflation is the gradual increase in prices across an economy. Price increases lower the purchasing power of money.
This might sound like a universally bad thing but it isn’t. It’s widely believed that a moderate amount of inflation is necessary to sustain economic growth.
It’s only when inflation runs too high for too long that problems begin to emerge.
High inflation is a sign that consumer demand is outpacing supply (demand-pull inflation) or supply chain problems are making goods more expensive (cost-push inflation).
An important decision every business makes is what to do with its cash💵.
Most thinly capitalized companies keep their cash in a business checking account.
But there are better options for businesses that have a year or more of runway. Much better! 🧵👇
Cash is the lifeblood of every business. Healthy businesses have more cash coming in than going out.
The healthiest businesses have cash buffers that enable them to weather adverse changes to their market or the economy.
Many businesses aren’t yet healthy but intend to be down the road.
These “startups” raise capital specifically to build better solutions to profound problems with the promise that the resulting business will be profitable and valuable.
Web3 believers assert that #web3 is in its early adoption phase and that the masses will come just like they have with new technologies in the past.
There’s some truth to this narrative but forces are at play that make #web3 adoption MUCH MUCH MUCH more challenging. 🧵👇
Everyone has probably seen a version of the tech adoption curve. The curves show that once a technology hits escape velocity it’s only a matter of time before it becomes ubiquitous.
What’s also clear is that technologies are “going vertical” faster than ever before.
The #startup ecosystem has been turbocharged in recent years due to massive capital inflows.
A downside is that the playbook has been lost around how to build a healthy business.
Being able to make money with a single product at low levels of scale needs to be re-learned! 🧵👇
Many Founders exist solely to will into existence their product/service offering. They get up in the morning ready to tackle the challenges presented by their ecosystem and obsess about delivering a superior option to their target customers.
Sounds good? Only kind-of-sort-of….
GREAT Founders exist to build DURABLE and PROFITABLE businesses. They know that the best way to build a great business is to solve a profound problem with a product/service that a set of target customers is willing to pay more for than the solution costs to manufacture.