The Kids Are Alright
“A change, it had to come
We knew it all along”Won’t Get Fooled Again – The Who
Over the past two quarters, industry participants and research analysts alike have all put forward their wisdom on what the venture capital landscape will look like in the coming months and year. Set against a backdrop of a public market correction, increasing inflation, rising interest rates and political unrest, it would be easy to sound the horns of Armageddon and “let slip the dogs of war.”
While today’s reality of declining valuations, layoffs, budget freezes and VC purse-string tightening make one want to grab a bottle of Tylenol or worse, what we are currently experiencing is nowhere near the wholesale correction following the dot-com bust of 2000-2001. I know because I was there.
While the warning signs for both meltdowns were similar – a heavily weighted tech sector in the S&P 500 index – there are some major differences between the earlier, hyper-speculative internet era (talking sock puppets anyone?) and today, where established tech companies saw massive growth spikes during one of the world’s worst pandemics since the Spanish Flu. COVID-19 however is a convenient scapegoat for a decade of cheap and plentiful capital that swelled the coffers of investors and companies alike. Such an environment has always, and unfortunately will always encourage complacency and irrational exuberance on the part of existing market participants which then attracts a tourist investor and entrepreneurial class who look to cash-in on what appears to be a financial free-for-all. A vicious cycle that can only end one way – badly.
What’s happening right now isn’t fun for anyone, but those who have lived through similar times recognize it for what it is – the end of one cycle and the beginning of another. If history is any guide, out of the ashes of today will emerge tomorrow’s Amazon, Facebook, Google, or Apple.
But in practical terms the question remains, what does this mean for the myriad of startups and their employees or investors? I have a few thoughts on this.
1. Technology Won’t Stand Still
Global technology innovation, even now, shows no sign of slowing. Many have commented that Moore’s Law is dead or coming to its zenith, and yet it’s still humming along. And all the while, new machine learning algorithms, natural language processing and advanced coding languages are ready to take off where Moore’s Law ends and usher in a new paradigm of technology advancement. And this doesn’t even consider the potential move beyond silicon to new metamaterials such as graphene that promise compute power up to 10,000 times that of today’s transistors.
These advancements, coupled with the continued decline of storage and compute costs, mean that less capital is required to ideate, develop, and bring to market newer technologies, thereby (i) increasing an investor’s return on investment in those technologies and (ii) encouraging more capital to re-enter the market to support additional technology acceleration. A virtuous cycle where everybody wins.
2. Culling the herd will allow companies to focus on what really matters – scalable growth
It takes time to build great companies with enduring products and/or services; Facebook, Google, Microsoft, Amazon, Apple, and others took decades to reach true scale. Unfortunately, the market lost sight of this reality, leading to a “growth at all costs” mindset that saw investors plow unsustainable sums into companies who then burned those dollars at an increasingly alarming rate. To justify this, new key performance indicators were developed that allowed companies to happily show that everything was moving up and to the right. But these vanity metrics had little to do with measuring actual success and when the firehose of capital started to slow, those that lacked a truly revolutionary technology or service or failed to properly manage their burn have found themselves alone in the wilderness and unlikely to survive.
On the flip side, companies that can course correct will not have to compete for investor attention against those with better PR machines or product-led growth strategies that generate massive user counts, but little real revenue or operating margins. This means that they can set out to do what they originally intended when launching their business – focus on building an enduring company, a great product and defensible market position. Additionally, as the frenzy subsides, startup CEOs will not be overburdened with team attrition, and having their best employees constantly poached by the “next hot startup”. The result is greater team cohesion in the long term and a better company all around.
This is not to suggest that companies should abandon a focus on hyper-growth; this is still their main objective as a startup. However, knowing the difference between fast growth and scalable growth is key. The former is driven by fear and enabled by poor discipline. The latter is achieved through thoughtful planning, ROI-focused capital spend and a zealot like focus on the bottom line.
3. Founder and investor expectations will once again approach equilibrium
The last ten years have been marked by an asymmetry in the relationship between investor and founder. Simply put, cheap, easy, and abundant capital made it a founder’s market allowing startups to impose lofty valuations, short diligence windows and limited governance rights on investors who feared missing out on the latest cool startup. This meant that important technology, go-to-market, and team diligence wasn’t getting done and many of the hard questions necessary for an investor to gain a fulsome picture were not being asked. Now some will try and say that years of investing gives them the knowledge to make quick decisions and move fast without a diligence deep dive. In certain cases that may be true, but in the main it is pure BS. There is simply no substitute for good quantitative and qualitative diligence.
This dynamic has now changed. Investors are finding they have more say during investment negotiations and the result benefits both parties. Key among these include:
a) Valuations: Valuations broadly have started to rationalize (e.g. drop), giving investors better ownership stakes in exchange for their capital, while making it easier for startups to “grow into” these valuations without torching cash. This makes the climb to the next round and valuation step up easier for the company and benefits all parties.
b) Governance: Investors are once again obtaining more appropriate governance rights and greater transparency into a company’s operations. The corollary is that company management benefits from an investor’s experience and pattern recognition when making strategic spending, hiring or GTM decisions.
c) Alignment: Here a + b = c. Reasonable valuations and proper governance help create better alignment between the company and its investors. They aren’t the only things but are good representations of the whole. This means investor surprises are usually kept to a minimum and management doesn’t feel they’re in a constant US vs THEM battle with their capital partners. In the end, a partnership emerges that encourages management to leverage their board member’s expertise as they fight the good fight out in the marketplace.
As I’ve said before, changing the world isn’t easy, but times such as these have led to the creation of some of today’s most enduring companies. For anyone worrying about their young companies, founders, employees, partners and associates, this period will be challenging, but rest assured we’ve been here before and will be here again, and as the song says…
The Kids will be Alright.
#ONWARD
