Not to age myself, but I’ve been in the software startup world for over 20 years. This means I lived through the 2001 downturn (as a startup entrepreneur) and the 2008 downturn (as a VC). After two downturns, the third becomes more of a “here we go again” rather than “what the hell is going on, life is over as we know it!”
Back in 2008, I was an investment partner at OpenView and we had just finished raising our second fund, closing a few weeks after the Lehman Brothers bankruptcy. We were lucky enough to close that fund and have strong institutional investors who did not waver in committing their capital during times of economic crisis. We had fresh capital to deploy but we didn’t act like it for quite a while during 2008/2009.
My Advice to VCs
Looking back on those years and the subsequent performance of that fund, I can’t help but try to draw some insights based on my experience since then. My advice to VCs going through their first downturn with COVID-19 would be:
- Don’t wait to invest: it is natural instinct to want to wait for the economic dust to settle before committing to startups. Back in ‘08, we kept kicking the can on what turned out to be great companies to invest in. You should also bear in mind that venture capital is a long term investment with a 5-10 year horizon. Waiting 6-12 months for the economy to improve may help your IRR, but waiting will hurt your multiples if you end up passing on great companies in the short term. Backing great companies with capital to weather a downturn, helps them to be ready to hit the ground running when the economy picks up.
- Don’t bargain hunt: back in ‘08, we had a mindset of bargain shopping, balking at companies’ pre-downturn valuation expectations. We were more keen to go for bargain deals that ultimately generated mediocre returns. I’m a strong believer that in venture – as anything in life – you get what you pay for. Expensive deals during a downturn are just as likely to yield great returns as expensive deals are in a good economy. And by the same token, a bargain deal during a downturn is just as likely to have a mediocre outcome as a bargain deal in a good economy.
- Don’t be a shark: don’t be the kind of investor who tries to squeeze founders on valuation and terms because they are going through a rough patch in a bad economy. Be fair with your valuations and don’t go back on terms you previously provided in a term sheet. If the downturn has a material consequence to the business that legitimately deserves an adjustment of deal terms or capital needs, work through those openly and collaboratively with the founders. A downturn only lasts 6-24 months, a relationship with founders will last 3-10 years.
The 2008/2009 downturn was in fact kind to a number of tech unicorns. Dropbox raised its Series A in October 2008. Instead of selling out to Apple in 2009, Dropbox decided to grow the business themselves to impressive success. Twilio raised its seed round in April 2009 followed by its Series A in December of that same year. Here are more examples of such unicorns.
My Advice to Founders
If you’re a founder looking to raise early-stage capital, you should keep in mind how Seed and Series A VCs tend to behave in downturns like ‘08 and COVID-19:
- Stage I – Portfolio Preservation: for the first 3-6 months, VCs tend to hunker down and spend a lot of time on their portfolios. The focus here is working with their companies to help them cut costs, contain cash burn, and making sure that they are properly capitalized.
- Stage II – Fund Preservation: in those first six months as the fund gets a good sense of its portfolio capital requirements, the partnership will then focus on adjusting their follow-on fund allocations. Invariably, the follow-on requirements will be above their earlier expected fund allocations, which means they will revert to reducing new investment allocations until the dust settles. This typically results in smaller checks and sometimes in fewer deals.
- Stage III – Pipeline Culling: with the constraints on new capital available to VC funds to invest and the general state of the economy, funds tend to raise the bar for the types of companies that they will consider for investment. They will still have a lot of qualifying calls with prospect companies as if it’s business as usual. But in reality, compared to pre-downturn, VCs will be more selective, more patient, and more rigorous. This means founders should expect more conversations to end with “we would like to track your growth for the next few months.”
- Stage IV – Opportunistic Investing: from months 6-18, VCs will make new investments very selectively with two general themes: (1) super attractive companies – disruptive, game-changing founders and/or capital-efficient economics with sustained growth through the downturn – will ask for and get reasonably good valuations; (2) attractive companies with reasonable economics and growth in attractive markets, but are likely under-capitalized, will get valuations below their expectations, possibly below previous rounds.
There’s plenty of data that has been published looking back on the 2008 vintage of VC funds. Check out Pitchbook’s Venture Capital in the Great Recession and CA’s US Venture Capital Index and Selected Benchmark Statistics.
Naturally, there are all kinds of exceptions to this perspective. Regardless, founders should expect that it will be much more challenging to raise funding during a downturn and it will take much longer than expected. Therefore, founders should lower their burn rate to the bare minimum and maximize the money raised from existing investors regardless of valuation.