The recent collapse of the stock market would indicate that we are entering a down economy. Economic complications from the global coronavirus pandemic are already impacting diverse industries like hospitality, construction, entertainment, retail, food service, and many others. In addition, many venture capitalists — including those at Sequoia — are attempting to prepare their portfolio companies for a new reality while claiming credit publicly for detecting a change in the wind.
This is my fourth “down cycle” in the innovation economy. I began my career as a venture capitalist during the recession of the early 1990s, and have managed as a venture capitalist, entrepreneur, and innovation professional through the downturns of the dot-com bubble collapse of the early 2000s and the housing crisis in the latter part of the same decade.
While our current economic crisis strikes me as different because of the deadly nature of Covid-19, many of the indicators for startups, entrepreneurs, and investors are already resembling prior economic recessions. Reflecting on those prior experiences may help us process what we are hearing in the marketplace and assist with preparation for managing external innovation through a down economy.
Cutting Through the Noise
It’s important to understand how the funding structure of the institutional venture capital market drives overall entrepreneurial behavior in a recession, and more specifically, following a stock market crash.
Traditional VCs raise capital from institutional limited partners (“LPs”) like pension funds, family offices & endowments. These capital sources automatically become over-weighted to venture as the stock market falls. As a result, these capital sources signal to VCs that the next fund may happen more slowly, or not at all. Traditional VCs then slow their pace of new investments to ensure they have enough capital to weather the downturn.
As a result, we are already hearing a variety of messages from traditional VCs:
- Some sound the alarm to explain why they are slowing their activity
- Some show bravado, taking credit for the fact they remain active in the market (peruse a selection of posts from the hilarious Twitter account “VCs Congratulating Themselves” if you don’t believe me)
- Larger firms with many portfolio companies, like Sequoia, may focus on advice for their startups to show leadership
Traditional VCs are frequently confident and vocal, and as early adopters of social media, tend to have far-reaching megaphones that allow them to set the tone for what’s happening in innovation.
However, corporations are not subject to the same kind of asset allocation balancing that determines when institutions approve the next financial-only venture fund. As a result, corporate innovation can march to the beat of its own drummer. Yourcorporate innovation team should therefore be available to leaders in the organization to explain how your venture capital, M&A, or business development program can provide impact in a downturn:
- Generating insights to help prepare for the future, because the current crisis will eventually pass
- Prioritizing support for existing investments
- Structuring mutual benefit with startups that will rely on corporate assistance more than ever, which includes commercial transactions without investments, and potentially M&A
- Pursuing new opportunities at better valuations with dedicated startup companies that have less competition
It’s true that some corporations will choose to quit now — DuPont Ventures announced that it is closing shop. But for organizations managing ongoing innovation, or for entrepreneurs attempting to plan for this new reality, it can be helpful to distinguish between existing portfolios and new opportunities. For each of these categories, it’s potentially beneficial to examine 1) what to expect, 2) what your existing external partners or potential partners may be thinking about corporate innovators, and 3) what you should do. The following analysis is my personal opinion of what could make sense in the current environment.
Defense: Supporting Your Portfolio
If you have an existing portfolio of innovation assets (including acquisitions, venture investments, business development deals, and even R&D projects), your top priority should be to protect what you already own, if there is still upside. Recognize that this is a responsibility and will affect your reputation.
1. What to Expect
Proactive “belt tightening” by VCs will almost certainly lengthen funding cycles overall, and this will impact most external innovators that are already your investment partners or commercial partners. Startups you’ve already acquired obviously won’t be affected by a slower venture capital funding environment.
The pendulum may soon swing to terms that appear to be investor friendly, but this can be deceptive. It’s one thing to reset valuations, but participating preferred multiples and full ratchet anti-dilution clauses often emerge during a downturn. In my experience, these toxic terms rarely yield positive results.
Many startups under-react or over-react. Portfolio company revenue and cash levels typically fall faster than expenses for companies that under-react, which leads to a cash crunch and a desperate need for new funding. Startups that over-react and trim the majority of their staff may find themselves unable to recover or resume momentum when the downturn eventually passes, becoming “living dead” businesses with no prospect for success. Threading the needle by reacting in real time to new information is difficult, and requires constant vigilance.
In addition to managing your portfolio, your own organization may become more conservative and ask you to justify your innovation activities and the return being provided to the parent corporation. Your CEO and CFO may be wondering whether what you do should be considered a luxury.
2. What Your Portfolio Company CEOs & Co-investors May Be Thinking
CVCs have abandoned portfolio companies in prior down cycles and your external partners may be worried about whether you will be there when they need you. This may be the greatest fear regarding corporate innovators in the venture economy.
External partners are likely worried about their own cash positions and viability. Many VCs will advise their portfolio companies to eliminate luxuries and act quickly to ensure they can provide for the basics.
Remember that entrepreneurs are probably more scared than the typical corporate executive. Most of these entrepreneurs have months of cash remaining and face an uncertain funding environment. On a relative basis, corporations are much more stable than most startups.
Overall, fear may be the greatest motivator for your external partners, when considering your existing innovation portfolio.
3. What You Should Do
Knowing that fear may be paramount, communicate that you intend to prioritize support for existing investments to calm any potential frazzled nerves. Do this by connecting with all your portfolio CEOs and co-investors to provide responsible leadership, staying in coordination with the chairperson at each startup. Ensure this is done with investments and commercial partners alike.
Accelerate the regular evaluation of reserves for your portfolio, which is usually done quarterly in most venture capital environments. It can be useful to “stack rank” the portfolio by strategic impact and financial viability. Be sure to understand how many months of operations remain for each startup. Ensure frequent and accurate reporting by connecting to the finance team at each portfolio company, so you know the cash position and “fume date” for each deal. Good communication can avoid surprises.
Encourage your startup CEOs to listen carefully to their customers, including those within your corporation, if relevant. You may be able to assist with the interpretation of what your colleagues are saying. While revenues may slip, expenses should be under the control of your startup teams — so advise portfolio CEOs to cut decisively if needed. Portfolio companies should shift spending to variable costs instead of fixed costs as much as possible, to maximize flexibility. Steve Blank recently published a framework I find useful for situational assessment and cost reduction. During a time of crisis, startups have less margin for error, so measuring, monitoring, and managing tightly are more important than in boom times.
Once you’ve communicated with your partners, performed financial analysis, and implemented controls, err on the side of supporting entrepreneurs while cutting investments that are no longer financially viable. Above all, be realistic. If you are managing an opportunity at the seed or early stage that hasn’t demonstrated product-market fit, ask yourself the tough questions about whether what you are trying to accomplish serves a real need in the marketplace, especially in an economy that appears to be focused on remote work in the short term.
Help with any commercial relationships in process to demonstrate that you bring more than money to your portfolio. Remember that to help your portfolio, you need to be prepared to jump through hoops internally and justify why what you’re recommending will deliver impact.
Offense: Scrutinize New Opportunities
A downturn may be the most attractive time to open new discussions, make new investments, structure new transactions, or start a new venture fund.
1. What to Expect
As with existing investments, the market may shift to terms that appear to be investor friendly, but look out for “pyrrhic victories” — entrepreneurs may be forced to accept toxic terms if they have no alternatives, but founder resentment could come back to haunt you.
Startup valuations will likely fall, although private markets typically lag public markets. It remains to be seen how quickly startup valuations will be impacted, and by how much.
Venture capitalists may have a greater incentive to be honest with you than entrepreneurs, but desperation may cause either to treat corporations as “dumb money” — remember that for some in entrepreneurship, you may still need to overcome this stigma.
Your own organization may de-prioritize new investment and innovation activities out of an abundance of caution, but this might not be the best course of action. The most successful startups are typically born during economic downturns. According to a 2009 Kauffman Foundation study, more than half of Fortune 500 companies at the time were started during a recession, including tech companies like Microsoft, Electronic Arts, Google, IBM, and Salesforce; and traditional businesses like Trader Joe’s, Hyatt, and FedEx.
2. What Prospective Portfolio Company CEOs & Co-investors May Be Thinking
Again, recognize that corporations have abandoned portfolio companies in prior down cycles and prospective partners may justifiably fear whether you will be reliable in the current environment.
As noted above, some external parties may think corporations are dumb money. When that view intersects with desperation, the result can be an entrepreneur who attempts to “fool you” into supporting their startup.
On the other hand, many institutional VCs and startup CEOs now recognize that corporations can bring competitive advantage to help startups survive and thrive. When seeking to work together with deep pocketed investors who bring more than just money, these parties may be energized at the thought of engaging with you, especially if they have prior positive experiences with your organization.
A combination of fear and greed will likely be top of mind for prospective external partners, when considering new opportunities.
3. What You Should Do
Remember why you started your innovation efforts in the first place. Continue to generate insights to help prepare for the future by reviewing new deal flow. But bring extra scrutiny to any new deals in a down economy, because capital flows will likely be tighter and it might be more difficult to find good partners to share financial risk.
As a result, consider increasing financial reserves per deal and decreasing the number of new investments, business development deals, and acquisitions. As part of this effort, put extra emphasis on financial diligence and aim for up to 24 months of cash, if possible, or visibility to cash flow positive operations. To accomplish this, emphasize thorough diligence, which remains more critical than ever.
When evaluating new opportunities, prioritize resilient business models, cash efficiency, and reliable syndicate partners who are honest. All of these can avoid the uncomfortable feeling of exceeding your target reserves per deal.
Some new investments may require recapitalizations, also known as “cram downs” or “wipe outs” that eliminate ownership for all existing shareholders. Pursue this path cautiously and attempt to avoid overly greedy terms that could cause long term damage to your reputation.
Again, recognize that startups will rely on corporate assistance more than ever, and when appropriate, start with commercial transactions first to limit downside and improve speed to market with new solutions.
Knowing that your own organization may be questioning everything, be prepared to explain internally why a down cycle can be advantageous for new deals. If your organization has financial resources and you have put out any burning fires, be prepared to go on offense. If you don’t have a legacy portfolio, it may be a great time to start new innovation efforts, including a corporate venture fund.
Remember that predicting what happens next isn’t that easy— there’s a lot we don’t know: we don’t know when this health crisis will subside, whether next winter will be better or worse, who will win the U.S. presidential election, and so on. In venture capital, the mantra is to participate in every vintage year for the same reason. There is simply more that we don’t know than we do know.
While downturns are difficult, they are rarely the time to cease all innovation activities if you expect your company to remain relevant in a decade. This applies whether you are managing your own business (as a corporate executive or an entrepreneur) or helping your portfolio companies as an investor. Down cycles are inevitable, and the next up cycle may be around the corner. Be prepared for anything, at all times.
This article originally appeared in Forbes.
