My Thoughts on the Current Market: on 20-Minute VC

Several years ago I made an appearance in a burgeoning new podcast called “20 Minute VC,” which by now needs no introduction. Harry was gracious enough to invite me back so this past week we recorded an episode discussing the current market environment.

Please download the episode here, if for no other reason than to make Harry happy :) but I’ve also included some quick notes below including a few notes I didn’t share in the podcast (and vice versa by the way — if you listen you’ll pick up much more than my quick notes below).

*******************************

Topics we covered:

B2B Companies

You haven’t seen the full extent to how the correction is going to affect you. We discussed why in Q4 you will see large renegotiations of SaaS contracts and increased churn rates. We talked about what startup CEOs should do in these situations and how to think about these renegotiations. Nobody will be immune because in a bull market executives are paid to “innovate” so they sign software contracts and run projects. In a bear market executives are paid to: consolidate the number of contracts and renegotiate prices.

What Do You Need to Prove to Raise an A Round?

Should you focus on growth? If you go more slowly will you die anyways because you haven’t shown more traction, more quickly? Harry posed these questions. I pointed out that throughout history building companies has always taken time and we as a market have put an urgency to rush growth rates. It takes time to sell in your software, get it implemented, prove the value, build a business case, gain executive support and then roll it out more broadly. In a market where people aren’t just paid to “innovate” but will need to show real economic value, expect gains to come more slowly. Burn through your cash quickly at your peril.

B2C Companies

We talked about how some companies saw an immediate decline in purchasing (for example if you’re in travel or hospitality). Other companies have only seen a slight decline and may be expecting demand to return to normalcy later in the year. That may happen. But I doubt it. The reality is that when unemployment sinks in demand is likely to get worse. 22 million filed in just 4 weeks — for comparison there are only 17.6 million people EMPLOYED in California. And only 8.7 million people lost their jobs in the whole of the Great Recession. When the dust settles from the initial joblessness and people have lost savings, don’t immediately find new jobs and this weighs on the stock markets, people will inevitably cut personal spending.

Biggest Advice I Give to Portfolio Founders?

We know that marketing dollars have fallen dramatically in Q2 so if you’re reliant on that, you have no choice but to act immediately. This is not a 2-month v-shaped correction. Get your costs down, renegotiate your supply contracts and extend your runway. Some people tell you not to waste your time talking with VCs right now. It won’t surprise you that I disagree with that. I stand firmly on “Lines, Not Dots” and think that if you want a decision in the Fall, planting seeds right now is sensible. It may take much longer to close deals than you’d like.

Do I Believe VCs Are Really Open for Business?

In a word: Yes. But not all deals are equal. Seed deals, for example, are easier to get funded than a late-stage deal for obvious reasons. A seed deal hasn’t already been “priced up” to a range where a new investor might be concerned about the valuation relative to performance. A seed company hasn’t ramped up its cost base. A seed deal requires a $2–5 million commitment, which is easier to consummate in a series of Zoom calls than committing $50 million, which calls for some in-person contact. But there are some deals that will get funded even though not necessarily seed:

• If you’re in an anointed category that will serve a post Covid-19 world well. Food production and distribution, group collaboration, remote training or education, sensor technology (tracking people movement, temperatures, etc), certain biotech deals.
• If you’re a clear “market winner” like Stripe, Robinhood or Airbnb. There are large sums of money to be invested and if investors can get comfortable with “downside protections” they’ll still write checks.

Of course I believe the market has slowed down massively. That’s not surprising since VCs are going through triage and also waiting for more certainty to return back to the market. I spoke about that more in this deck that I wrote for the SaaStr conference in early March 2020.

How Do I Advise People When Raising Money in a Hard Market?

Be humble. Raise when you can. A strong balance sheet will matter in the years ahead. Optimize for a 1 not a 0 more than exact valuations now. Valuations may have changed and “price discovery” in private markets is harder to determine. Public markets are transparent and resetting mental mindsets is easier because market expectations are very clear. In the private markets it’s much harder to know and you’ll have VCs who don’t want to take “mark downs” so may not immediately encourage you to accept a new reality.

We also discussed what the M&A market looks like now but I’ll leave that if you listen to the podcast.

We Talked About VC Reserve Strategies

This is an “inside baseball” topic for VCs. But when a fund writes checks into a portfolio company it typically “reserves” money to invest in future rounds. Every firm has a different reserve policy but reserves are especially difficult for smaller funds. Many solved this problem by writing “SPVs” (special purpose vehicles) to fund their best deals as they scaled. But you can’t easily raise an SPV in a downmarket to help bridge a company going through a transition so firms that haven’t set aside proper reserves may find themselves wiped out in some deals in a down market. We spent time talking about why “pay-to-play” deals are back on the table and why these deals happen.

The podcast also has a detailed discussion about how we at Upfront think about reserves in terms of:

• The importance of diversity across time (to pick up technology shifts / platform changes and market changes)
• Why we create a portfolio with some diversity on the “J curve” (we do 89% Seed & A, 11% B’s. Of our early-stage deals we do 33% Seed, 66% A’s)
• Why recycling is important, but why without exits you might even be forced to stop paying management fees for a while

What Will Happen with LPs in this Economic Market?

Harry asked me whether I thought LP “defaults” (not funding the VC commitments it made) would go up. I discussed why I didn’t think this would be a widespread problem. What will happen is that some LPs will need to scale back the number of VC managers they have on their roster.

What is the Most Important Role a VC Plays?

1. Picking great talent. We are fundamentally in the business of backing exceptional people, and knowing how to find them, judge their skills and future potential and then earn their trust IS the job. We of course need to understand markets and market dynamics but many people understand this from an analytical perspective. Understanding markets AND people (and earning the respect of the most talented people) is much harder.
2. Knowing the limitations of the founding team. Every great player from MJ to Kobe to LeBron needs a supporting cast. Our job is to know the strengths of the leaders of the companies we invest in and knowing their weaknesses. We need to be able to show them why complementing their skills with other talented executives and sharing in the power will yield better results. We need to have access to great executive talent and they need to trust us to join the companies we back.
3. Paying close attention to the psychology of founders. We need to know when teams need to be left alone to work and know when they need help sorting out problems. We need to spot when a founder is hitting a major stress phase in life or work and be there to help and also know how to get the most out of people through being great mentors.

We Discussed My Biggest Weakness

Being jaded by seeing what “didn’t work” and assuming it therefore won’t work now. I discussed that extensively in my post about being fooled by your expertise (which is really worth reading). In short, many founders have “naive optimism,” which is to say “they don’t know what they don’t know.” So sometimes the fact that they haven’t learned what ISN’T possible makes them try anyway and have a blind belief it can be done. We discussed that in the show.

How Do I Encourage Dissent Between Amongst the Partners?

At Upfront we value conviction over consensus. We are looking for a strong opinion, well researched and with strong conviction. We are willing to underwrite deals where a partner has conviction (usually with at least a second supporting it) even if some others disagree. They have to be “down the fairway” for Upfront: a $3–5 million check, 19–22% ownership in a sector we know well. But if they are we don’t mind dissent. We actually encourage it.

Do I Think That the Days of Owning 20% as an Investor are Over?

In short: No.

Some founders prefer to spread their investor base across many different VCs in an early round. That’s ok. That’s a decision every founder gets to make. If that company does incredibly well from start to finish that may work out better for them because they kept stronger control over governance and may have been able to negotiate better personal economics.

But when companies go through tough moments — and let’s face it most companies go through tough moments at one time or another — having a strong lead who has long-term conviction in your business can be a large benefit.

So there are different approaches and different kinds of founders. There are also different kinds of VC firms and not all are worth taking that bet on.

Ultimately we look for founders who want to go on a long-term journey with us. So I say that at Upfront we really look for three things:

1. Product-Market Fit
2. Founder-Market Fit
3. Founder-Upfront Fit

I discussed these extensively in the podcast.

Quick Fire Questions:

1. Favorite Book: (For the times I recommend: The Accidental Superpower, The Absent Superpower, Disunited Nations, all by Peter Zeihan)
2. A Great Board Member I Worked With: Rory O’Driscoll: (did the work, rolled up sleeves, cared, had great humor)
3. Hardest Thing in My Job?: It’s hard being a VC right now. Not anywhere nearly as hard as being an entrepreneur. But since asked, I covered some reasons why it’s tough out there being a VC right now.
4. Is It Important for a VC to Build a Brand?: Yes, critical. To win the best deals entrepreneurs need to trust you and want to work with you. Decisions on whom to work with are very emotional and the intangibles of brand plays a big role in the final decision.
5. What Do I Know Now That I Didn’t Know When I Started: Sometimes it’s ok to let a problem simmer, even when I think I know the answer. Let founders work some things out for themselves.
6. A Recent Company I Invested In: Solve. A “true crime” video game. Here’s a bit more about the company but tune in to the podcast if you want to hear me talk a bit more about why I was so excited to back Tom Wright.