VC Winter is here, and it's going to be freezing

[Here's a Letter I sent to Heroic's portfolio today. Some recipients suggested I publish it, as it may be of service. So here it is, unedited.]

Dear Heroic Portfolio Founders, CEOs, and Friends,?

You have never received an email like this from me, and it’s probably been four years since I have communicated with the entire portfolio at once.?Here are my opinions (not necessarily those of any institution or LP or partnership or other people at Heroic) on what’s happening right now in the world of venture funding.

Venture capital funding is about to freeze — basically entirely — for the next 3 to 5 months.?Some time in the next 5 to 15 months, funding will pick up again, at a good pace, but at much lower valuations.

I would give a 90% probability to this scenario, with a 10% chance that there is some sudden improvement in the macro conditions that probably only temporarily forestalls the moment (“Sudden outbreak of peace in Ukraine!” “Fed backs off and continues QE yet again!”).?

Winter is here, and it’s going to be freezing.

The last times this happened were 2008 and 2001.

If you’re under 40 years old, you’ve probably never seen this before.?The distance in time since the last such episode makes for a potentially especially dangerous brew of conditions.?Many late-30 somethings and early-40 somethings are now in Important Roles as “Partners” (that means real partners and social promotion partners) at venture firms or other financial institutions.?Many are also in C-level roles at various companies.?Many of these will think they “lived through the 2008 downturn” while they worked at MegaCap company or a Management Consulting Co or an Investment Bank and therefore believe they know what Winter looks like because they saw the cancellation of free food or dry-cleaning or a reduction in annual bonuses or the cessation of daily trash pickup in their cubicles.?They don’t.?In wintry conditions, such individuals will operate very fearfully.?Many will seek to save their careers before anything else.?Be aware.

If you are sitting on 24+ months of cash runway, you’re probably fine, but you should make sure you keep your company in good trim.?If macro economic conditions are not damaging your growth in the coming quarters (e.g. a possible recession), you probably don’t need to make any sudden moves.?Perhaps, in general, allowing natural turnover to occur and declining to back-fill jobs quickly will be enough, so long as your growth rate is relatively stable.?Maybe the only major question facing you is whether you can grow enough in the coming 18+ months to justify an upround from your last valuation in a lower-valuation regime.?If you can’t, consider making some tweaks in your planning to get yourself enough runway so that you can achieve an upround despite what will be much lower valuation multiples once deals start getting done again.?Aim, in the coming 24+ months, for positive cash flows or very low burn with an intelligent (even if not a screaming) growth rate.

If you’re a revenue-generating company and sitting on less than 12-24 months of cash runway, unless you are in the top ~5% of growth companies in your field (and perhaps even then), you should consider making very strong reductions in spend immediately.?The very, very top growers may be funded in the next 6 to 8 months despite tough conditions.?But pretty much no one else will, unless they have taken major belt-tightening steps now.

I don’t mean half-measures.?I don’t mean “all teams must review their hiring plans and shave them by 15%.”?I’m talking about reducing your net monthly burn by a LOT.?Maybe 50%.?Maybe more than 50%.?I mean cutting every single absolutely not necessary program and person and every single non-top-performer — all at once — as fast as you possibly can.?This is not the time to try to be “nice.”?In these circumstances, such attempts to be “nice” are, in fact, actually unkind.?The job market is very strong now, and people can get hired elsewhere faster than at most other times in history.?Failing to take strong measures now almost certainly sets you up to be LESS kind later.?Don’t set yourself up to have to do multiple rounds of small cuts in the coming quarters so that everyone at your company is paralyzed with fear about what may come next.?Don’t disappoint your courageous and clear-sighted top performers who are ready and eager to carry forward with you in spite of difficult conditions by trimming only around the edges instead of removing everyone and every program that your best people know must be removed.?(Of course, it should go without saying, but let’s say it to be clear: when letting people go, one must do it with kindness as you would always do.?Some of the toughest people I know are also the most human in these moments.)

If you have less than 12-24 months of runway, you should consider making all of these cuts even if your growth rate will suffer immensely.?In Wintertime, going from 80% to 30% growth rate may well be the exactly right choice if it gives you another 15 months of runway.?You may even have to sacrifice growth entirely — and witness even negative growth — for a couple of months by giving up some customers who aren’t really working for you.?The growth can start again right after that — on a smaller base — in a much healthier, sustainable way.

In most cases, in my experience, your investors will thank you for being very prudent and very aggressive in your prudence.?In truth, they may or may not actually reward your efforts for strong measures with further capital.?But they will almost certainly?notreward half-measures.

Another nuance: it is important to look at your capital base.?If you don’t have very, very deep pockets around the table already (I mean one or more of the top tens of venture funds in the world), you should consider taking even stronger and swifter steps to right your ship.?The bigger funds can go the distance in these circumstances — even if they don’t.?The smaller ones usually just can’t.

Not only that.?You should look at who, exactly, is the partner from the top tier fund who works with your company.?If it’s a Top Dog person, you’re probably in better shape than not, on average.?VCs are humans, after all.?When the going gets rough, the top partners often favor their own deals.?The deals from the Junior Partners or “Vice Presidents” or “Partners” (the ones who carry that title but used to be called Analysts or Principals or VPs before everyone in the world became a Partner) are too often disfavored, unfairly or not, because the Top Dogs want to save their own reputations by propping up their own deals.?If you are not working with a Top Dog, consider taking stronger defensive measures during the coming Winter.

If you are a pre-revenue or barely-revenue or otherwise very early stage company that has raised only a relatively small amount of funding to date, your situation is probably different.?It is likely enough that the major problem in your situation is that you may well have raised capital during very heady times (read “lofty or insane valuations”) that will almost certainly not be back when you are next raising capital.?Partly because there are or were likely no measurable benchmarks against which to justify the prior valuation, you need to plan for some possible unanticipated valuation and dilution pain in the future.

In this scenario, if you have 24+ months of cash runway, sudden moves are probably not needed.?But you should consider keeping as much runway as you reasonably can.?

If you have less than 24 months of runway, you should almost certainly reduce your hiring plan, and if your crew size is more than a handful of people, you should almost certainly reduce some of your team and other expenses so that you can avoid raising capital till at least a year or 15 months from now.?If that is simply not possible, then you should consider going out of your way to telegraph that the last SAFE note on which you raised capital need not be the final word when it comes to raising your next round.?In other words: avoid needing to fundraise till at least Fall 2022; be prepared for very different valuation expectations when you’re out there; and be proactive in telegraphing that you are willing to adjust valuations as may make sense in the new conditions.?Venture capitalists are often too afraid to broach the question of valuation expectations once they see the price tag on your last SAFE note, but being proactive in communicating flexibility can make them feel they have permission to discuss it with you.

Please be aware, as you may have heard me say before and as you may have observed for yourselves:?

Very few venture capital investors are brave.?

Very few venture capital investors make up their own minds.

Very few venture capital investors have the authority to do deals even if their web profiles and self-description suggest they do.

In other words, help is not on the way.?The same exact groupthink, trend-following, and hysteria that got your company — or other companies you know — stupendous valuations in the past years will yield exactly the opposite result now.?Fear will govern.?Deals will not happen.?Investment processes will be frozen.

BTW: even down rounds will not happen.?Which is to say they will barely happen.?One of the great myths of Silicon Valley (broadly defined) is that savvy investors will appear and do down rounds.?For better or worse, most venture funds are just not set up to do down rounds.?It’s not in their DNA.?There are many good and not-so-good reasons for this.?But the point is that you can not and should not count on “rational investing practice” to result in successful down rounds for good companies.?Most venture capital firms that will continue to invest in the coming 24-36 months would much rather wait to do a (lower-multiple) upround for a fresh company with a clean cap table than propose an investor-favorable down round for a good company that will, in the absence of that down round, potentially just go out of business.?Venture capitalists even have a much-used (and inappropriate) word for this.?They say they want to avoid the “brain damage” of a down round.?Too often that means nothing more than that they don’t want to do the hard work of sorting out a deal with a many-handed cap table that will inevitably disappoint some existing shareholders.?So, whether out of ease of use, abundance of alternative opportunity, laziness, or rational economic intelligence, they just won’t want to hear the story of a company that is good but needs a down round of fresh capital.?There will be exceptions to this, of course, and perhaps most often at the very early stages (where the cap tables are not complicated) or at the very late stages (where there is a lot of revenue and a relatively big business that is worth the rescue).?But prepare for it be a much rarer event than you might expect.?Perhaps irrationally, down rounds are very rare.

After the frozen investment period begins to thaw — I am estimating that it will start to thaw in the coming 3 to 5 months — deals will happen again, and they will happen at a decent pace.?Please expect and know that the venture capital class have been waiting for this moment for a long time.?They have had so little leverage for so long, and soon it will be back in their hands.?Some VCs will be businesslike.?Some will be gleeful.?(Some might even be privately vindictive!)?They will cherry pick great deals.?They will expect, demand, and get much lower valuations.?Please plan accordingly.?If you had a nonsensical valuation at your last financing, you should do all you can to prepare your company to chin that bar when you have to raise capital again — as far in the future?as you can manage.?I don’t expect substantive deal?terms?to change a lot this Winter, but I do expect valuations to come back down to earth, by a factor of 40% to 80%.

Also, when the thaw comes, the prudent companies (those that had less than 24 months of runway and that made it through the toughest months of Winter) that took hard steps in May / June 2022 will be, on balance, favored by investors as compared to ones that did not.?Investors will look upon CEOs, founders, and leadership teams who used this time to make difficult decisions as superior leaders who are more investable, in general, than ones who declined to do so.?

Not only that, but the companies who use this time as an opportunity to get really excellent will probably be surprisingly rewarded by capital markets when the winter ends.?Companies that manage to reach positive cash flows will likely be hugely rewarded, even if they are not growing?quite?as fast as they would have been otherwise.?Companies that maintain good growth but low net burn will also probably be rewarded.?In some cases, as in almost all macro conditions, some of these companies will even command lofty valuations (though not as lofty, as a function of multiples, as we have seen in the past few years).?There is hope on the horizon.?But hope soon will depend in large part on decisive action now.

In the past, you might have heard me say something like “anything that happens on Wall Street happens much faster and harder in Silicon Valley.”?Now is such a time.?The correction in the Nasdaq, the overall bear market, the slaying of tech stocks — the effects are all coming thick and fast to venture capital.?It doesn’t really matter WHY the Wall Street correction is happening.?It probably matters only that it appears to be happening?and?that no sustainable counter-correction appears to be in sight.?The combination of years of QE, the arrival of (short- or long-lasting) inflation, the changes in the Fed rates, Russia/Ukraine, etc. — it’s all making for downturn conditions that appear to be “here to stay” for a while.?I encourage you to act accordingly.?I would discourage you from listening to anyone on your team who thinks it’s gonna pass fast.?I predict it won’t.

Over the past handful of days, I have communicated with some of the most senior people in our industry, including veterans of VC who have made boatloads of returns for themselves and LPs over many years, in good conditions and bad.?They are all, at least privately so far, saying the same thing.?

Winter is here.?Some companies will die that shouldn’t.?Some will make it through.?But the best chance of surviving and thriving will almost certainly lie with leaders who give their companies as much runway as they can muster.

Michael?

Of course, any email like this benefits from some set of reasonable throat-clearing additional comments and disclaimers.?(Why??Well, because once in a while some devious person or another can hold up an email like this and say “well, what did you mean by XYZ on ABC date?” and just remove the intelligence, oxygen, goodwill, and truth from any room in one fell swoop.)

-Of course, YOUR company may be different from any other in the world we are describing.

-Any given company is, naturally, different in some important ways or another.

-Your investor base could be, too.

-Your industry could be special (for better or worse), and some sectors will fare better than others, as usual.

-Circumstances can change, too, and quickly, including foundation conditions.?The author of this email (that’s me!) reserves the right to change his mind in general or specifically at any time.

-This email contains forward-looking statements.?Predictions are not guarantees.?Obviously.?