Like everyone else who watches the news, we too have heard about the yield curve inverting, raising the question, “Is this finally the end of a ten year expansion?” Also like everyone, we don’t know. What we do know is that there is a greater level of risk to the economy than there was 6 months, 12 months or 18 months ago.
What has changed? Ignoring politics (really), tariffs and tighter immigration threaten to stifle two major engines of continued growth domestically – namely consumption and talent availability. Meanwhile, the global economy is slowing due to normal late cycle dynamics, the arrival of emerging economies to a highly “developed” state, as well as greater systemic drag from the budding of protectionist policies and rogue nations. In the tech economy, some (not entirely unexpected) cracks are appearing with WeWork struggling to IPO and Uber and Lyft on long stock price declines following their IPOs. Changing investor expectations resulting from these events befalling tech’s favorite children will no doubt trickle down into mid-stage and early-stage investing.
We’ve thought much about what this could mean for our portfolio companies and how we help prepare them to weather any dip. Our approach is to look at increasing macro risk through three lenses: Customers, Capital and Acquirers.
Customers: Our companies are not immune to belt tightening among their own (mostly B2B) customers, domestically or globally. Many of our portfolio companies serve large global enterprises, so even slowdowns in non-U.S. regions can have an impact on their metrics such as a higher cost of customer acquisition (CAC) – fewer customers in the market with budget to buy, so it’s harder and costlier to find them; and lower lifetime value (LTV) – customers are more likely to cut or reduce spending. Of course, this “LTV to CAC ratio” is a key software-as-a-service indicator. Under circumstances where there is pressure on the top and inflation on the bottom, we advise our companies to focus heavily on customer success and retention and to be less aggressive on sales team hiring and burn to maintain efficient growth.
Capital: The common retort to a potential economic downturn’s effect on startup fundraising is, “Hey, VC funds have so much money. They have to invest it.” While it’s true that venture capital funds raised more than $130B in 2018, surpassing the 2000 dot-com peak, that same comparison reminds us not to take levels of “dry powder” for granted. As we saw in the dot-com collapse, in a downward market, dry powder can stay on the sidelines or focus inward on existing portfolios, reducing the number and levels of new company financings. We certainly expect our best companies to maintain access to capital, but the bar will go up for those in the middle. Given this, we are advising our companies to raise capital (within reason) while the getting is good. Indeed, our best companies all have very strong balance sheets that could last several years or more if needed.
Acquirers: Just like investor capital can stay on the sidelines, corporate and PE acquirer money can too, despite the abundance of both. In a downward environment, exit horizons are likely to extend – all the more reason to encourage companies to bolster their balance sheets and prepare for hyper-efficient growth if needed.
Especially in a changing environment, startups serve themselves well by understanding the investors from whom they are trying to raise capital. How an venture investors look at a possible downturn will depend on their own fundraising cycle. Investors at the tail end of an investing period will pull back quickly, reserving more capital for existing investments and worrying about their own fundraising plans. Investors with fresh powder will have a heightened preference for efficient growth and will likely take their time in deployment to time-average the possible effects of falling entry prices and because their own fundraising cycles will extend as well. Things will simply go slower.
We are neither sounding the alarm nor plugging our ears, just staying attuned to our markets and prepared to adjust if necessary.