Take a deep breath

After four months of market volatility, with half of the steep decline just in the last month, the conventional business wisdom has rapidly switched from exhilaration to one of doom and gloom. This is especially true in the tech economy and in startup land.

Here is the good news. When social sentiment is either extremely good or extremely bad, you can be certain that the truth falls short of the extreme. I am not the first to point out that social media and “professional” media channels magnify the already excitable human condition. A turning tide that exposes who is swimming naked also jars us into believing that the unlucky companies that now need to layoff employees and cut burn were doing amazingly well until the tide went out. Not so. Most of them have been swimming naked the whole time, or even walked naked to the beach!  

Burning too much capital to make too little progress is always a risk and symptomatic of an unhealthy startup, whether the market previously overlooked and rewarded perverse behavior with a financing round, or not. “The market” is not interested in doing that anymore.

The sugar high was wonderful. 2020 and 2021 were a once-in-a-generation opportunity for business model risk taking and liquidity, but now we’re back to the meat and potatoes of balanced cash burn and responsible growth. For the startups that bake this into their strategy, there is the added opportunity that talent markets will likely be more favorable in tech – and possibly beyond if there is a recession. This, after a ten-year run of tightening and then white-hot talent competition. It shouldn’t be lost on anyone that two of Chicago’s greatest growth stories of yore – Redbox and Grubhub – were built during weak labor markets of the financial crisis. In times of economic weakness, outsized resources and gains go to the victors.

I am also uncertain about the conventional wisdom that high interest rates will be terrible for the tech economy and startups. Yes, a high interest environment traditionally hampers companies and industries that require high levels of investment capital, because risk capital instead chases yield. That makes sense, but with very few pundits or operators ever having lived through a high interest rate paradigm (including me), it makes it easy to oversimplify (and to be naïve?).

As evidence of interest rate risks to tech, many point to crossover funds that funded the exuberant late-stage rounds of 2020 and 2021 now putting their pencils down in the private markets. Their reduced willingness to fund excessive pre-IPO pricing risk is just starting to reverberate down to mid and early-stage funding rounds. However there is a strong case that what we’re seeing makes sense after the pandemic and has little to do with interest rates. As Natasha Mascarenhas said for TechCrunch in “It’s not a startup reckoning, it’s a recorrection”:

Over the past two years, tech rightfully became more critical than ever for the services that it provided to the average human, whether it was empowering an entirely distributed workforce or helping us get access to health services via a screen. It also became vulnerable. Pandemic-era growth has always had a caveat: The tech companies that found product-market fit, and demand beyond their wildest dreams, are the same tech companies that knew their win was at least partially dependent on a rare, once-in-a-lifetime event that (hopefully) would go away one day.

While we’re still waiting for good 2022 private valuation data to form, public comps seem to support Natasha’s view. The BVP Nasdaq Emerging Cloud Index is a good public proxy (and canary in the coalmine) for where private market valuations may go. What we see is that public comps are normalizing to pre-pandemic trend lines…

EMCLOUD Index

BVP Nasdaq Emerging Cloud Index Performance

… and valuation multiples are back where we started.

EMCLOUD EV/Rev Valuation Multiples

BVP Nasdaq Emerging Cloud Index EV/Revenue

Of course, now is a moment in time, and trends may further deteriorate. Even if they do, my bet is that they rebound.

Apple, Google, Microsoft, Amazon and Intel hold more than $600B in cash. Google, Microsoft and Intel will keep acquiring (okay, Apple and Amazon do less of that) to maintain their moats, just as they’ve always done. The longer tail of tech giants like Salesforce, CISCO et al will too. The ultimate demand for new technology, business models and unique talent remains high.  

All of this is to say that things may not be as bad as they seem or what we hear. Nevertheless, plan for the worst; hope for the best! So we are coaching our teams:

  • Cash is king/queen: This isn’t a new refrain. Manage your burn and maintain runway. I love to see a SaaS business adding $1M in revenue for each $1M of cash burned – hard to do but easier if you burn less and grow a little slower. I also love seeing net burn below monthly revenue. So, if in a month you’re doing $100K in revenue and burning less than $100K that’s terrific. (Of course you also need to be growing to want to do that.) The days of burning $5M to get $1M in ARR or burning $500K in a month to produce $100K of revenue in that month are gone.
  • Manage your expectations: I met with an at-launch company last week and asked them how much they were raising. “5 on 35”. My response: “wuh?” As the market quickly shifts, it’s easy to lose track of the market or blow a conversation by being tone deaf. Consider that early-stage rounds will likely revert to the typical 20 to 30% dilution we used to see, and later stage rounds up to 20%+ from the 10% they fell to.
  • Beware the middling third: The top third of companies should continue to have funding opportunities, even if at reduced valuations. The bottom third will continue to need to sell out or shut down. The middle third is likely where things will change the most. VCs and founders were spoiled in the recent runup with many mediocre performances still earning follow-on rounds. This feels far less likely now, and companies in the middle third should instead seek solid exit opportunities or cash flow breakeven.

Good luck to all and remember that in the asymmetric performance curve of startups, iconic companies can and will be built during downturns.

The vaccines are coming; now what?

The arrival of several highly efficacious vaccines – whose rapid advent is itself a modern technological marvel – allows us to finally ask with more temporal certainty, “what’s next?” and “what’s next for tech?” While at the same time we hunker down and take precautions for what may yet be the most painful and dangerous months of the pandemic, we may now hopefully look to mid-2021 when a semblance of normalcy for our lives and all sectors of the economy is likely to return.

Just as we planned and adjusted when COVID hit, it’s time to do it again. Naturally the exercise is largely dependent on how a startup was initially affected by COVID and whether those trends will have inertia or fully abate. However, every startup needs to consider implications to cash and the longevity and viability of remote working in a less contagious world:

The few companies that benefited from COVID have to make bets on behavioral inertia.

Whether a D2C e-commerce brand or a telemedicine startup, each startup that benefited from COVID is asking the question, “how long will this last?”. In many cases, we expect modified behaviors to have permanence. It’s reasonable to believe that many consumers who recently crossed the abyss to online grocery ordering may want to remain there much of the time, or that remote employees will want to keep working from their new pied-a-terre in the country. In fact, many of these changes have taken structural form, including the flight to the suburbs and office down-sizing. Purchased homes and new leases have permanence. We also know that it won’t all stick. Zoom stock is down 27% from its peak a month ago as the light at the end of the pandemic tunnel emerges. While there is no single expectation that fits, VC Fred Wilson suggests that a 50% reduction in excess demand caused by a shock is a reasonable place to start in planning for the aftermath. If companies can flex that assumption in their model up to 75% and down to 25% while still achieving solid growth and efficient burn, that is a robust plan.

Not yet party time for everyone else

So for the companies that were deeply impacted by COVID or for those that were relatively unaffected, is 2021 going to be a party? Not likely. For example, the travel industry may take years to return to pre-pandemic levels. Some of this will be a result of lingering contagion or fear and some the result of entrenched behavior change. Even less affected industries are not likely to see a rapid jump back to pre-pandemic levels as demand and job recovery always take time. The exception may be in consumer goods and experiences, where an unprecedented increase in consumer savings rate over the last six months may portend a release of spending in 2021 when confidence and job prospects improve.  We are encouraging our most heavily affected companies to take it slow in 2021 and allow each increase in spend to prove itself with commensurate demand before taking on more expense.

Cash is still king

While venture capital didn’t experience the apocalyptic decline some predicted – and in fact had a banner third quarter this year – much of that favored a few late stage winners or COVID standouts. Moreover, the standards and milestones of success have not loosened because of COVID. Startups are still expected to at least double year-over-year to be fundable through Series B. That was uniquely difficult in 2020 and will remain so in 2021. Without a free pass on a bad year, most companies that limped through 2020 will have to preserve cash through 2021 as they slowly claw back towards growth. This will be very hard for most, and there may yet be casualties.

Remote people and culture are here to stay

By 2025, it may be that the most permanent vestige of the pandemic at startups is remote teams and culture. Before COVID, about 10 to 15% of companies we saw had majority remote teams. With that number now near 90%, we think it will settle in the 50 to 60% range in a few years. The barriers to productivity have largely fallen as we’ve all learned to work remotely, and the benefits of being able to hire anywhere, including on a contract basis, can make a startup more nimble. As a geographic focused investor, we’ve thought a lot about what that means for us. While we still believe our geographic focus brings network effects in our ability to find and help startups, we expect more of our investments to have a considerable remote workforce, albeit with a mid-content HQ. You have to host the holiday party somewhere!

While it is a relief to look ahead to a brighter 2021, we know that the next few months will be difficult for all, directly painful for many and tragic for some.  Let us all be safe and good to each other as we transit this last leg.

That new CARR smell

With politics and the pandemic hurtling towards a crescendo this week, I thought it would be a welcome distraction to talk about something equally as controversial… Contracted Annual Recurring Revenue (CARR). (The comparison is mostly a dark joke, so spare me any indignation.)

We started seeing CARR enter the startup lingo about five years ago, but typically only inside of enterprise software startups in their tracking of implemented revenue versus signed revenue. Then CARR started appearing in investor decks, then companies wanted to be valued as a multiple of it instead of ARR, then companies started talking about “verbal” Contracted Annual Recurring Revenue (VCARR). Oh boy.

Here is how we think about ARR and CARR and how they relate to each other:

Your current GAAP (recognized) monthly revenue x 12, excluding any transactional revenue

= ARR (very conservative)

+ transactional revenue that is highly certain to recur (example would be “metered” subscription models like say charging $1 per truck load in shipping)

= ARR (nominal)

+ additions to ARR expected in the next 6-12 months (or maybe before end of calendar year) that represent increases baked into contracts that are already implemented. This could include highly likely increases to recurring transactional revenue for certain models

= ARR (liberal)

+ “ARR” that is contracted but not yet implemented or billing, representing what will be billing immediately after it is implemented

= CARR (nominal)

+ increases to CARR that represent contracted annual price increases over time in contracts not yet implemented, including future “recurring transactional” revenue

= CARR (liberal)

+ contracts you think you have a verbal on

= VCARR (bullshit) = bullshit

We generally prefer the use of ARR (nominal) and CARR (nominal) both in working with our companies and in evaluating new investment opportunities. We prefer these versions because their constituent parts are more transparent and objective. The difference between them is also very clear. ARR is monthly revenue today x 12, and CARR is monthly revenue if we finished all implementations today and multiplied by 12. We loathe VCARR.

But don’t you want to take credit with your BoD or an acquirer/funder for everything you have signed? Of course, but if there are too many assumptions in the underlying structure of a metric, its veracity collapses, potentially requiring backtracking, reforecasting or undermining your story with a BoD or acquirer/funder. Using nominal definitions, it is okay to say our ARR is X today, but in six months, we already have Y baked in, representing contracted increases. Similarly, many companies will talk about TCV, which includes the value of multi-year contracts.

These days, we are seeing most companies valued by some multiple of ARR (nominal) or expected year end ARR (nominal). If the former, credit is usually given also for unimplemented contracts (CARR – ARR). If the company is later stage with a long history of successfully implementing contracts, there may be no discount on the multiplier used for the unimplemented contracts. For an early stage company say with $1M in ARR and $1M in unimplemented contracts (CARR = $2M), the discount on the unimplemented multiplier might be as high as 50%, given more uncertainty about implementation success.

What matters the most is that whatever metric you choose, it is clearly defined, transparent and able to be objectively measured. Otherwise your new CARR will smell fishy.

Apocalypse Later

In March the consensus among venture investors – especially ones who had witnessed the .com boom, financial crisis, or both – was that dark times were ahead. Sequoia and others quickly warned their portfolios to significantly cut expenses in expectation that demand would disappear, in most cases regardless of industry or business model type. We did too. 

Now almost six months later, the new narrative is that things didn’t turn out as badly as we thought. As evidence, startup financings remained relatively robust in Q2 and into Q3, there has not been a second wave of tech layoffs (and hiring has even restarted) and most companies are seeing a return of demand, albeit often at a muted level.

So did everyone overreact in March? I don’t think so. On the one hand, returning demand is a great thing, on the other hand, there are signs of a structural disequilibrium between main street, public stocks and the startup/venture market. There is also a foreboding sense of complacency with truncating cash runways in many venture portfolio companies.

Main street, public markets and venture/startup markets are interdependent, more now than ever given ubiquitous reliance on software, internet and technology across the economy. This was much less so the case in 2000, or even 2008. Today the link is tight:

Main Street: Main Street is hurting. Literally. Wade through the pile of Amazon and Instacart deliveries at your door and take but a few steps to realize small business, restaurants and many services through every city and town are in the shit. While government stimulus has helped – and we can likely expect more – it only puts food on the table and doesn’t yield the confidence consumers need to drive demand. Many startups sell to main street consumers or to the businesses that sell to them, so demand in most industries is undeniably muted.

Public Stocks: It is said that main street is today and the stock market is tomorrow, and this explains why employment can be down 600 basis points in 6 months while stocks return to previous highs over the same period. Okay, if that’s true then we might ask, “will the future (2021, 2022) be as good as 2018 and 2019?” That seems unlikely. Even if we had a vaccine today, the rest of demand and employment recovery is likely to take years, as it usually does following a recession. I am not a market timer, but right now it feels like the market is over-handicapping a quick vaccine and recovery.

So where does the venture/startup world fit in? In the end, public markets represent both a major input and output to the venture/startup model. Most funds invest money from institutional investors who hold a bulk of their holdings in public stock. When those go up, institutional investors “allocate” more to venture; when public stocks go down, those investors “allocate” less to venture. The public markets are also a major exit path for startups, both through direct IPO and M&A to public companies. When the markets drop, both paths deteriorate. So if the market drops again, which seems likely, there will be less money going into venture funds and fewer paths to exit for startups (or at least at lower exit multiples).

Admittedly, the above cycle is incredibly “macro” and “on average”, while startups and venture funds live by the power law. If you’re lucky enough to be a “COVID bump” startup or to have a few in your portfolio, that is terrific. However, the majority of startups are now growing slowly (in venture terms), chewing through the limited runway they worked hard to extend in March and April. This is what I refer to as the ticking time bomb of venture and startups. These runways expire en masse between late 2020 and mid 2021. 

As happened in March and April when VCs focused inwards, I anticipate a recurrence of inward preoccupation when this corpus of slower growing startups become “workouts”. Entrepreneurs and investors will have to pick winners and losers. This will lead to much fallout in existing portfolios but perhaps also a muting in excitement for funding new startups – at least for some time. (It will also be a good time for strong startups to buy weakened competitors and win their customers.)

You can’t be a VC without being an optimist, and I do believe tech is performing and will come through the other side of COVID stronger than ever. But we need to remember that everything is linked, and the current disequilibrium may yield to more pain in the short term.

Bootstrapping 2020

Crowdfunding, ICOs and COVID. What do these have in common? All three have at one point or another been described as a deathblow to venture. Venture has and will survive all three of these. While we’re in the early innings of the pandemic, an initial freeze in venture has thawed, even if at a more tempered cadence. VCs are screaming on twitter that they’re open for business, and even we have a signed TS with a company right now, so we can scream too.

But should startups take venture in 2020? That is a more complex question. Paul Graham’s much cited and seminal piece Startup = Growth is a great reminder of what venture capital is for: to fund rapid, steep growth. The cost of venture capital is high. Often cited as a 20-30% APR – a reasonable approximation for the average cost of capital for “successful” VC funds – the true cost to an entrepreneur who succeeds can be as high as 100% APR or more. Remember, if you succeed wildly, you have to cover the costs of your VCs’ failures.  Now, if that’s the case, you are probably much richer than the VC in the end, so it was worth it. Now back to the growth…

Raise your hand if you have rapid, steep growth in 2020. Uh huh. Most startups will have a terrible 2020 in startup = growth terms. We expect the majority of our companies to fall between a -25% decline (for some consumer and B2B transactional businesses) to a +50% (for stickier SaaS businesses). We are also lucky to have a few “COVID bump” outliers. More on that below.

When you’re swimming, it’s good to know where the rest of your pod is. Here is how we see the growth profile of startups in normal times and in 2020. Don’t get caught up on exact numbers, business model etc. This is meant to be illustrative:

In normal times, we see lots of startups growing 25 to 100% annually. Few of these get funded unless they have bulky ARR (say 5M and above), in which case they oftend find a “growth” investor with the right appetite.  Then there is a decreasing tail towards and above 200% annual growth. Most venture deals get done in this range with “hot” deals above 200% growth. 

In 2020, this distribution has shifted left, roughly centered around 0% growth, maybe slightly above. Then there is a long desert to a small second mode of “COVID bump” companies, where the hot deals are getting done now. These tend to be in e-commerce, virtual care, remote collaboration, online education… you know, the obvious. They get a lot of buzz and are exciting, but most of the announcements you see are companies receiving supported from insiders.

Venture capital is not for survival. It is very expensive if things work out later, so if you’re in the middle of the pack now, do your best to avoid taking venture until you emerge on the other side. Barring the fortune of being in the COVID bump – where pouring gas on the fire makes sense – I’m convinced that the best companies and happiest founders will be the ones who bootstrapped through 2020.