Observations and Macro Thoughts: My Letter to LPs During COVID-19
Early last week I sent a Quarterly Update out to the LPs of The Syndicate Fund. I included my observations and macro thoughts on what is happening and what will happen in the startup and venture capital world during this unprecedented time. I am sharing it below exactly as it was shared with my investors:
I write this from Florida where my wife (Sara), children and I got “stuck” when the US largely shut down mid-March. We were here for my mother’s 70th birthday and friend’s wedding, which ended up getting cancelled. On Sunday, March 14th we were set to fly home when Minnesota cancelled schools. The logical decision was to stay here and wait it out. There are worse places to be self-quarantined than Delray Beach, Florida. We have help with child care while we work remotely, it is easy to get some fresh air and there is a neighbor’s pool where my kids can swim.
It is interesting to be at a moment in time that you know you will always remember. Everyone in the world will have their own story, new paths will open while others will close.
For the last several weeks I have been observing the markets, public and private, speaking with numerous other investors throughout the country and working closely with both our portfolio companies and other startups that need help. It has been an incredibly emotional few weeks, filled with the ups and downs of the founders in The Syndicate Fund family and the broader startup ecosystem that I actively try to engage and help.
This is an emotional time. At both the personal and professional level everyone has uncertainty in their life right now. Even if you are immune to the stress you are undoubtedly working, interacting or helping others who are. And it can be exhausting for everyone involved.
Short Termism in Crisis
Right now, people are frantically working “in” their businesses and not “on” it. In other words, everyone is so busy with the day to day right now that they are not focused on higher level strategy. Getting their heads above the day-to-day is often hard for founders to do in a normal environment, and we are now not in a state of normal. In the midst of crisis, startups, like all of us, need to take a breath and make sure they don’t lose sight of how short term decisions we make today will affect the long term viability of their company. Too often, short term decisions made under high levels of stress and exhaustion can be fatal in the long run.
One of the most common pieces of advice I have heard given to founders over the last few weeks is “act quickly and decisively.” While well-meaning, this advice is likely going to cause several founders to jump into action prior to thinking through the ramifications of their decisions. Entrepreneurs are already wired to act quickly. I agree that swift, decisive actions are important in times of crisis, however more appropriate advice for founders would be, “Act quickly to put together a plan with a sensitivity analysis, then act decisively to execute on the path that will lead to your best chance at success.”
Will Capital Retreat from Markets?
The mood among the venture community has shifted to one of recession expectant. While opinions on how bad and how long differ, everyone thinks things will slow significantly. Given the percentage of the economy that has been shut down, this view probably isn’t wrong. Every venture fund I have talked to has advised their portfolio companies to draw down any debt they have available to them and to close any rounds they have open, however possible. There is a real fear that venture capital deployment is going to slow down significantly for at least the next 12 months.
There are reasons to be optimistic. One is that there is capital out there. In 2008 there were roughly 100 venture funds in the US. From 2008 to 2009 venture capital investment in the United States dropped about 25% from ~$29b to ~$22b. By 2011 ~36b was invested. In 2019 more than $100b was deployed to venture investments and depending on your source, there are now around 1,000 venture funds in the United States. Nine hundred of those funds are a new phenomenon since the Financial Crisis — micro funds, or funds that have less than $100m of assets under management. How this new class of micro funds reacts over the next 12 months will have a dramatic effect on the startup ecosystem. Almost all of these funds have committed capital to deploy. Yet the uncertainty in the world has frozen many investors in the short run. Going forward, fear may cause a longer term gulf, despite the significant amount of dry powder out there in the venture capital community.
These fund managers are worried about the health of their existing portfolio, the ability to raise their next fund, their existing LP base, access to uncalled capital, and how round valuations are going to trend. While I am positive I am missing other concerns, these fears alone could slow capital flow down. In many ways they could become self fulfilling. For example, if enough funds slow down deployment then valuations will certainly decrease, so an investor may think, “why invest today when I can potentially get the same deal in 6 months?” Regardless of the reasons, startups need to be prepared for a more difficult capital environment.
To Follow or Not To Follow?
The slowdown outlined above has already started. A portfolio company has already had a term sheet pulled. Investors have begun to say that they are reserving capital for their existing portfolio rather than making new investments. I don’t doubt that this is true but is it the right strategy? You tend to never get in trouble for doing the expected thing, what everyone else is doing, if it doesn’t work you have lots of company. Right now, the generally accepted best practice is to help shore up the balance sheets of your existing portfolio and many investors are already taking this approach. Unfortunately, many of those funds are also slowing down or even freezing new investments. Often, crowd mentality can drive you to poor investment decisions.
While the strategy of recapitalizing your highest performing companies can work, larger funds have the benefit of removing some future financing risk. Micro funds will not have that ability. They can not carry a large portion of their existing portfolio through an extended recession.
Further it is impossible to make unbiased investment decisions into your existing portfolio. Often times this is a good thing, you have more information so you can potentially make a better decision. However, in the current environment this bias could lead to putting capital into a company without proper runway. One of the hardest parts of my job is telling founders that are wonderful people and are often friends “no.” Today, there is even more emotion involved, my “no” could mean a company dies, making it even more difficult to approach the decision or truly weigh the additional financing risk without bias.
As hard as it is, you need to take most emotion out of the follow-on investment decision. I have personally been through a failed startup as a founder. I was fortunate to have some great investors around me at the time that told me no. As hard as it was in the moment, in hindsight it was better to fail fast than to eek out a slow death.
If the decision was mutually exclusive, I would continue to make new investments rather than recapitalizing existing portfolio.
Fortunately, it isn’t. I believe a strategy that involves freezing new investments and/or a blanket recapitalization of a portfolio will underperform in any fund setting, large or small. Making smart follow-on investment decisions into your existing portfolio when the team, market, product and capital structure is in place is a smart decision. Additionally, micro funds should continue to invest in companies and founders they believe in today. Like Warren Buffett said,
“We have no idea — and never have had — whether the market is going to go up, down, or sideways in the near- or intermediate-term future.”
We are making long term investments, in companies that we believe add an incredible amount of value to the industry they are in. In ten years when we look back on this moment in time the next three months could be the ideal time to make investments, no one truly knows. If you close up shop you will miss it.
At the end of the day, fund managers need to make sure they work on their business and not just in it, just like a startup. Making rash, short term decisions will have a significant long term impact. Pulling a term sheet today may save some capital for an existing portfolio company but it will certainly have a negative effect on your deal flow and your future ability to invest in great founders.
Remote, remote, remote work & The Adoption Curve!
A final observation is around the acceleration of Everett Rogers’ adoption curve. The adoption curve as explained by Wikipedia:
“The technology adoption lifecycle is a sociological model that describes the adoption or acceptance of a new product or innovation, according to the demographic and psychological characteristics of defined adopter groups.”
Clear? It wasn’t for me and I already knew what it was! Because a picture is worth a thousand words, the model shown below is the Rogers adoption curve where technology adoption by a market essentially moves from left to right. Geoffrey Moore came along later and said there is a “Chasm” between early adopters and early majority. This jump is where most new innovation fails.
COVID-19 is going to end up the catalyst that drives mass adoption of many different technologies. It is going to force startups across the “Chasm,” as Geoffrey Moore so eloquently put it. Remote working technology is the obvious example right now but this rapid adoption is not silo’d to remote work. Food enterprises are amongst the many already talking about expediting their digitization plans in a variety of ways.
Further, I believe you can draw a parallel from Everett Rogers’ adoption curve and apply it to new product innovation: Innovators = Idea Stage, Early Adopters = Minimum Viable Product (MVP), Early Majority = Commercial Ready, Late Majority = Mature Product, Laggards = Antiquated Product. Often, new products sit around as ideas or MVP’s forever. They never cross to a commercial ready product. Not only is COVID-19 driving the adoption curve, it is also going to drive ideas that have been on the back-burner into production.
Many of our own portfolio companies have already launched new products or offerings that were previously on the back burner. A common theme from founders is “while time spent on the road selling or fundraising has slowed, we have re-focused efforts on product.” Some of this product and business model innovation is driven by necessity. Companies affected the most by COVID-19 will likely need to innovate in the short run or be well capitalized or they will die. But the acceleration of innovation isn’t only being driven by necessity. The best leaders also understand that in this new environment there are new opportunities to grow in a positive way.
Final Thoughts
World changing events require thoughtful action. The majority of the conversation to date in terms of advice, blogs, social media and the news has been focused on the mitigation of downside risk. For startups, scrapping old plans, rethinking the future, and understanding how to just survive is probably a good first step. However, those that aren’t thinking about the new opportunities this event will create could miss out on a once-in-a-company chance.
Venture capitalists, on the other hand, are in the risk taking business. A significant percentage of startups are going to go out of business by the end of 2020. We certainly have an obligation to help our portfolio of investments and the other startups in our communities. Like founders, we should adjust our strategies and adapt to the new environment. However, the majority of our time should not be spent mitigating downside risk. The funds that provide outsized returns in this vintage will continue to support entrepreneurs, continue to invest and understand that there is still opportunity in this environment.
