Editor's note: this is a guest post from Shmuel Chafets, general partner and vice chairman at investment firm Target Global.
It is now clear that we are on the tail end of the eleven-year bull market in the VC world.
It was obvious it would not last forever, but it was absolutely unexpected that this would be the way it ends. The combination of a once-in-a-century public health crisis and a complete meltdown of the financial markets is a lot to take in. But it is important to remember that the healthcare and financial crises, while of course closely connected, are not exactly the same. We must be careful to deal with both separately.
Like every other investor in the world, the last few weeks have been an endless stream of Zoom meetings with portfolio companies, co-investors and founders. The overall reaction to the crisis has been similar all around: a mix of moving to home office working, cutting costs, furloughing people when needed, and thinking through how the short-term situation impacts the business. There have also been questions about government support, while trying to find ways in which the current unusual situation might benefit the business.
The industry has very quickly developed a standard for dealing with the COVID-19 crisis, and implementation is fast. In many ways the COVID crisis is easy to handle: it’s a complete black swan, it’s external and it's a high-intensity emergency situation. You cut cut cut, and wait to see what you get from governments and how we emerge out of lockdowns and back into life. It’s the time of crisis that lets leaders shine. There’s a lot of glamour in being a wartime leader taking care of his troops (via video call). But the financial crisis could last much longer. There are fundamental things broken in the economy, and although we all hope for the famous V-shaped recovery, this may very well be a long, unglamorous climb back up.
The start-up/venture capital industry can be very misleading. Funds work in 24-36 month fundraising cycles, and most (responsible) funders keep 9-12 months of cash in the bank. So unlike retail or hospitality, the real hit to our industry is yet to come.
A big part of the VC industry has never actually seen a downturn. The age of investment professionals, even partners, has dropped significantly. The hunt for the next Zuk has filled VC portfolios with 20-something entrepreneurs whose understanding of the 2008 crash came from watching The Big Short. Many other investors are “grey hairs”, who moved from the financial industry to partake in what looked like the best party in town. Many of the newcomers see the last few years as the norm, and are now having a hard time understanding and adapting to this new situation.
Clearly, adaptation is needed, which isn’t necessarily a bad thing. The balance of power in the venture capital world shifted profoundly in the last few years, as the long run created a sellers’ market. This is apparent in both board oversight and secondary transactions. A notorious example is the reckless rise and fall of WeWork. But, to be fair, all of us have been affected, to one degree or another, by the spirit of the times.
Both early- and late-stage valuations have been on the rise, a trend that comes from the sustained growth in both deal size and valuations for all rounds. In 2019, the average A round valuation was 10% higher than the average B round in 2012, while B round valuations almost doubled. Round size also ballooned on the back end of higher salaries, higher spend and the “grow at all costs” culture.
The overfunding of the venture capital industry has led to a disconnect between public and private market valuations, which we saw hit hard in 2019 when big and long-awaited venture-backed IPOs backfired. The 30%+ drop in public markets hasn’t really set in for venture-backed firms, but it inevitably will. And that may be a good thing, long term.
Founders tend to think about this as “VCs trying to take advantage of the situation”, and in a minority of cases, that may be true. But overall, the adjustment in pricing happening right now is the only way the industry can continue to attract capital. Venture capital needs to provide better returns than the liquid public markets, and a valuation adjustment will keep the capital flowing during the crisis.
Changes are inevitable. Venture capitalists must use boards to exercise oversight and guard against excess. Insane competition for unproven “hot” deals that have made “founder-friendly” a watchword, will require straight talk. Telling the founder of a company experiencing massive losses to stop booking private jet flights may not be “friendly”, but it is essential.
Secondaries are another area that needs reform. When I started in the VC industry, the purpose of secondary transactions was to let founders take a little off the table in order to make them comfortable on the way to their goal. That is the right thing to do. A founder in the fifth or sixth year of his entrepreneurial journey, and three to five years away from an IPO, should be able to cash out a bit and take a small piece of the value that has been built.
But over the past few years, secondaries have become a tool for wealth creation that misaligns investors and founders. We have seen massive abuses: secondaries done in private; money-losing companies whose founders have built fortunes; CEOs with significantly more value in the personal investment portfolio than in the company they manage. Again, WeWork provides an instructive example.
The same is true for salaries and perks overall. The industry has been inching up in compensation levels, almost equalizing startup compensation with established, profitable companies. Startup salaries will go down, but hopefully equity compensation will go up. The traditional startup deal of low salary and real upside is one of the things that make our industry great: it creates the ownership mentality that’s so important to making startups succeed.
Lastly, I hope this crisis gives all of us a good dose of humility. Over time, quick and big money – both on the founders’ and on the investors’ side – is one of the things that has made the industry less pleasant (at least in my mind) and is a catalyst for a very ugly phenomenon (#metoo) which the tech industry should be clear of. At its best, the startup world can be a great equalizer: a place where people can earn honest money and make a difference in the world. This is a great opportunity to reconnect to that ambition.
This crisis is a significant one. Recovery will take time; doomsday pessimists say years, die-hard optimists talk in terms of months. As usual, reality will be somewhere in between. One good aspect of this crisis is that it ends the debate about whether we are “in a bubble”.
Another is that it will allow the venture capital industry to leave behind some of the bad practices we picked up in the later years of the boom and get back to basics. The key to success requires reading the new situation with fresh eyes and making the necessary corrections in business practices and expectations.