19 May Paul Jones: Thinking About Down Markets
It’s been a decade of good to great times in the high risk/reward entrepreneurship and investing space. Ten years is a long time in the sector, and there are a fair number of entrepreneurs and even VCs who can’t say they’ve ever lived through a serious down market. They are about to have that … experience.
Every down market has its own quirks, and no doubt the first one triggered by a pandemic will follow a unique course. That said, most if not all down markets share some essential features, and this next one will be no exception. Herewith some thoughts on what down venture markets look like, generally and with respect to the one getting started as I write.
- Valuations will come down, at all stages. This is probably what pops into most people’s minds when they think of a down cycle in venture capital. Down markets are associated with decreasing risk tolerance and less expansive visions of success. Increased perceptions of risk coupled with lower expectations for reward equal lower prices.
- Subsidiary deal terms – note particularly liquidation preferences – will shift from entrepreneur-friendly paradigms to investor friendly paradigms. The changes will supercharge valuation declines and increase focus on control provisions as a risk-management strategy.
- Earlier stage investing will take the biggest hit. Investors in extant deals, the farther along the more so, will focus their attention and dollars on deals that have already made it past the higher risk early stages. Portfolio triage, by funds particularly and the fund community generally, will favor existing companies with nearer-term, lower-risk paths to exit. Even early stage specialists will be more inclined to double-down on their winners than make de novo investments in launch-stage startups.
- Profits – well, positive cashflow – will take over as the driving “success” metric. This trend was already taking shape in the waning days of the good times. Look for it to accelerate as the market turns down, and investors become more time/capital sensitive in their evaluation of opportunities.
- Some sectors will do better than others: a few may even prove counter-cyclical. The same trends you see in the public sector will play out in the venture sector. Healthcare (particularly pandemic-related but even more generally) will fare well, for example, and alternative energy (with the collapse in fossil fuel prices) less so. Companies that fit well into notions of what a post-pandemic “new normal” looks like will also buck, at least to some extent, the larger down-market trends. (Look, even, for some irrational exuberance and maybe even some sort of “dot pandemic” sector developing.)
- Flyover country will weather the storm better than Silicon Valley. This is a subtle but important point, I think. Places outside of the larger venture centers did not participate, to anywhere near the same extent, in the good times to the same extent as their venture center counterparts. Deal sizes, valuations, and terms in Flyover Country didn’t spike to anything like the levels seen in Silicon Valley. They just don’t have as far to fall, and they won’t. Paradoxically, quality Flyover Country entrepreneurs with quality ideas might find their location less damming than in the recent past, all the more so if they were already pitching their deals as less time and capital intensive than their venture center peers.
The point in all of this is that as much as the market trends will impact everyone, and as much as those trends bode ill for most everyone, the nascent down market in the high risk/reward entrepreneurship investing space will affect different entrepreneurs and different investors in different ways. There will even be some winners. A down market is no more a time for a “one size fits all” approach to entrepreneurship or venture investing than an up market. It pays for everyone, on both sides of the table, to think through their unique circumstances and ask how they match up with the broader market trends, and how they might buck those trends.