How a recession impacts startups, VCs, and LPs – and the smart changes startups, VCs and LPs should make within the next 30 days

This is not the first time we have seen an economic downturn hit our venture-backed startup universe, but each one has its own unique characteristics – and no one really knows just how long it will last. Elon Musk predicts that this downturn will be 12 to 24 months, which is just perfect for a VC seeking to double or quadruple returns to LPs above what they would otherwise be.

While there is uncertainty, there is also near certainty of a few things. Net net, now is a very good time to be investing in startups or investing in a VC fund. Look at how all these realities impact the performance of a VC fund. Young or inexperienced founders and investors that were not active before the recent Covid boom should remember what the fundraising climate was like in the years before.

• Valuations come down, and the VC exits when the economy has recovered 3-9 years later.
• Startups lower the size of their next funding round, which in turn lowers pre-money valuations when startups attempt to sell not more than 20% in a single funding round.
• Startups will make that money last for 24 months or more; a smaller round means more austerity. Overspending by startups is the cancer of a booming economy. No more offering every employee to take an Uber home every night in New York and goodbye to the Michelin star chef cooking lunch for the royal employees in San Francisco.
• Layoffs from large tech titans and startups alike hit the pause button on the talent war and create opportunities for success at VC-backed startups. Execution is all about people. Really good startups are born and developed at this stage of the game. You can now begin to understand what a great vintage of venture capital this will be. Startups can hire talent at lower price points and total compensation packages while implementing austerity measures making cash go further and get more done. More talent leaves the large tech titans and goes to startups. More talent leaves other startups or doesn't get hired now that rounds are smaller and this talent is available for your startup to hire sensibly.
• Less VC money to go around is a good thing. Weaker VCs fail to raise LP capital and large VCs slow down investing while waiting for the lag in valuations of private markets to catch up with the knife drop in public valuations / multiples. VCs tend to also reserve more capital for their existing portfolio companies.
• Historically some of the best startups are founded during recessions. Think Microsoft, Airbnb, Pinterest, Electronic Arts, Slack, WhatsApp, Square, Uber, Instagram, and many others. The multiples VCs and their LPs made in these companies are much higher because of the recession timing of their early investments. When large companies lay off employees or cancel non-core development projects, employees leave voluntarily or forcibly with departing cash to give them time to talk to customers and start a new company that their former employer is no longer working on or is less likely to do so now that it's back to their core knitting.
• Technology continues even if the stock market crashes and in fact, customers need to buy and pay for cost-saving solutions or new technology that increases sales and productivity. The new startups born during recessions often have "must have" solutions driven by the need for every startup and large company to increase performance now that there is a squeeze on multiples and valuations.
• VCs recap their portfolio companies to provide all good portfolio companies with a minimum of 24 months runway, buying shares at the last pre-money valuation despite many of these companies doubling revenues and key milestones, just to take advantage of the panic. This is the mark of a smart VC with the discipline to remove the risk of uncertainty around “What is this economic downturn really going to do to this startup?” VCs end up owning more by the time of the exit, at what is essentially a bargain buy price. I always feel a bit guilty doing these recap rounds in the first days of the downturn. We just end up owning more of the company and everyone goes home and relaxes knowing we have a certain 24 months’ cash in the bank for every portfolio company. I'm not saying this should happen. I'm just saying that it does.
• A return to DD. Before an economic downturn some portfolio companies pass on our VC fund when they see we are going to do real DD, calling customers, examining the quality of each revenue stream, expenses, truly understanding sales cycles, true in and out cash flows, off sheet reference calls, etc. During the booming spring and summer of 2021 deals got done in days or hours with no DD led by inexperienced, touristic VCs. When the stock market crashes, the venture deals return to real DD and take weeks to close rounds. It takes time to do the work. Work is good. This is a return to sanity.
• Good startups should complete a rigorous self-audit looking at every single line item of expenses, literally line by line, and agree on a new operating plan. Founders need to figure out how they’ll get to cash flow break-even with the cash they have in the bank now, or recap raising a round and create a new operating plan with that new amount of cash. We plan for sales to remain flat when we do this with our companies. I did this when I was a venture-backed founder when the dot-com bubble burst. Every single cash line item. Even decide which vendors need to be truly paid, renegotiate 180-day payment schedules and re-negotiate with everyone. Pay less! Spend less!
• 18 months cash runway from each round becomes min 24 months runway. Rahul Vohra from Superhuman (one of our portfolio companies) famously wrote about maintaining a perpetual 24-month runway when Covid first hit. That’s one interpretation of becoming default alive or freeing your startup from the tyranny of VCs via the path to profitability.
• Startups must recognize which VCs are just taking meetings and which ones are writing checks during these weeks. Many VCs pause new investing during the catch-up lag period of private markets lowering valuations to mirror the public valuations. The stock market is real-time and drops like a knife. Private markets must take in the arrogance of early VCs and their founders pushing bubbly valuations and let the real world kick them around and watch burn push the bank balance to zero before deals get done at valuations that reflect a new set of lower multiples. That is the lag. Experienced VCs are playing the lag and, oh yeah, they are taking meetings. Just because you have 10 meetings with VCs on Sand Hill Road next week does not mean you really have momentum for your raise. So now you start to feel the heat of that burn rate. Founders should be skeptical that they are just taking meetings and not getting cash in the door. Get cash in the door.
• Certain types of startups, such as international, hardware, or capital-intensive companies with longer time horizons to revenue and profitability (think semiconductors), have a harder time raising funding. Recognize which kind of company you are and test the waters by talking to VCs with dry powder. There is a funder for every good company even during the darkest days.
• Not changing your plan is stupid. Change your plan. Review everything. Evaluate every single dollar your startup is spending and have discussions with your cofounders and VCs to run a process reviewed by multiple people and advisors. This is healthy stuff to do during any economic cycle. This is what we do for a living.
• The 30-day rule. Startups should make decisions within 30 days to lower burn rates and position for default alive or raise capital to extend their runway to 24 months. Complete the review and implement the new plan within 30 days. It’s hard to fire a guy and see him crying in his car in the company parking lot two hours later when you know he has a spouse and a 3-month-old baby waiting at home, but this is the hard work. Better to save some of the passengers on the Titanic rather than sink every man, woman, and child to the bottom of the ocean. A good startup CEO knows how to fire. Look, this is hard stuff – but it’s also an opportunity. Every company has a bad hire that should be let go to where they can be more successful. I always tell myself that the people I am firing are the most marketable people on the planet and they will survive this and be better off somewhere else that’s so thankful to hire them. No shame in being part of a 20% purge.
• Being a deer paralyzed in the headlights is what you don’t want to be. Go through the exercise now and just do it. There is a big graveyard in Silicon Valley from the CEOs who just kept bragging about the quality of their team and watched the bank balance hit zero and the blood (talent) eventually leaves the body and the company dies.

The big takeaway is that experienced VCs are secretly praying for an economic downturn when the behavior gets so sloppy during the boom times. No DD, crazy stupid valuations of $75m to $100m for a company with less than $2m in revenues, funding rounds too big resulting in premature spending, hiring and growth, horrific spending decisions by startups, addictive high burn rates that lead to more and more funding, higher liquidation stacks for founders to clear at exit, VCs getting crushed by other VCs. The return to sanity is good for founders, great for VCs and amazing for LPs.

Exit valuations come down now but are expected to return to normal levels after the market recovers in 12 to 24 months’ time, which is normally less time than a VC holds her position. VCs are not day traders. We hold for three to nine years before the definitive IPO or M&A exit. So the entry point for investing comes down now and our exits should be fine when we sell after the economy has recovered. Working against us is our ability to sell small slices in secondaries if the growth in valuations slow down. But, in reality, our portfolio is still at huge valuation upticks that we can still sell 5-30% at a $2bn valuation when our first entry point was $8m to $25m. Secondary markets slow down during the downturn but still exist for the strong performers.

The impact of the downturn-driven lower entry point investment valuation means the overall impact on the fund of top performers will be amazing. If the round size falls from $25m to $7m, that means the pre-money just dropped from $100m to $25m. If we exit for $1bn considering dilution, the Multiple on Invested Capital (the MOIC) could not just double but truly return a lot more cash to the LPs in the fund. This is very good news for LPs and VCs and, in the end, great news for founders, too, for not skipping over the work and finally doing things the right way. Lower entry point, same exact exit point years later. Startups are all about execution, and execution is all about team and talent. Our VC team acts like a heat-seeking missile in search of the best talent. Talent becomes much easier to attract and retain during times like these.

With all that said, I am such an optimist that I struggle to imagine any slow down to our portfolio companies when they leverage innovative technology to deliver so much value to their customers. These customers would be crazy to stop paying for the killer ROI of their solutions, and VCs would be crazy to abandon their portfolio companies and any chance to support and own more of these valuable assets growing while the value of the USD, Euro, and Yen clearly will fall. This is the place to store wealth and value. This is the place that is growing true value. Behind every good startup is a good funder. There will always be competition to invest in the best startup – even during the most uncertain of times. Again, it’s all about talent and that’s where we go. Given my years in the business, I do welcome a return to sanity and welcome the newest generation of VCs and founders to learn how to operate in the real world and not the fantasy world that was the summer of 2021. Now is a great time to have dry powder to deploy into startups. P.S. At 7BC Venture Capital we are actively deploying capital into early-stage startups through to Series A.?