It’s an unusual time in the markets. With high levels of public market volatility — the first we’ve seen in the age of social media and true real-time information — it feels like everyone and their grandmom is expecting a downturn. “We’re in the nth year of an unbelievable bull market!” “Most of the country doesn’t have any savings!” “Multiples and valuations are out of control!” “When the tide goes out, we’ll see who is swimming naked!” Pick your favorite doomsday one-liner, and it’s likely to fit the conversation. Then you have real successful professional investors like Bridgewater’s Ray Dalio who can dig deep into “the why” of now — read his latest post here, it’s quite good.
Much of this can trickle down into the startup ecosystem. There are many reasons for that, such as private equity and crossover investors investing earlier, or the fact that LPs in VC funds are affected by public market swings and could, theoretically, hit some VC firms to feel the pinch. You’ll see posts like this on TechCrunch about various VCs warning their portfolio founders to brace themselves for a cash crunch, and today USV’s Fred Wilson reiterated an important point he often returns to, that in the game of startup financing, it’s a game of going for growth or profitability, and eventually, valuation multiples compress.
I am expecting a downturn at some point. Maybe it will be 2019, or 2020 — or even 2021. Who knows. Yet, I keep wondering, that even in some downturn, both the U.S. (on a global stage) and specifically the Bay Area (within the U.S.) could become even more attractive regions for investment. USV’s Albert Wenger has been writing his book, World After Capital, which lays out the argument that money is no longer the scarce asset driving the economy, but rather, it’s attention. Samir Kaji of First Republic has chronicled the unbelievable rise in the number of new funds. TechCrunch’s Kate Clark has done a round-up of the largest “private VC” rounds of 2018, and there’s a whole other list for just $100M+ financings led by Softbank’s Vision Fund.
Money has been coming into the U.S. and the Bay Area specifically at a rapid rate. Now that everyone knows the stakes of a Facebook-like outcome, there’s more money looking to fund and fuel web-scale network-effect businesses. On top of this, the cost of bringing projects online has fallen, it’s become more fashionable to play the startup game, and so forth. Add to the mix that many foreign countries’ economies shift away from or toward natural resources, so we see massive direct and indirect investment into technology. This doesn’t even yet account for a bear-case scenario of all the private Bay Area juggernauts which are primed to IPO next year — if those all hit, and assuming local investors and employees own at least a third six months after IPO. the cash windfall to the Bay Area will surge past the days of Facebook’s offering.
This has placed a huge strain on the Bay Area, of course, resulting in intense competition for resources — mainly housing and talent. Home prices are moving in lock-step with higher salaries, to the point where many investors are hunting for deals outside the area, where teams are now starting off distributed or with a plurality of offices to locate some functions outside of the Bay Area costly square footage. A successful seed investor once remarked to me that he views “the traditional seed round” today for a good or proven founder to be akin to having a “free first move on the chess board.” More people are starting companies here, and there are more funds to help them get out of the gate.
If my analysis so far turns out to be correct — that if there is not a downturn, things will remain great for Bay Area founders; and if there is a downturn, the local conditions for raising money will get even better — how could a founder play this to his or her advantage?
Getting capital in the earliest stages continues to get easier. (Yes, I know for some it’s hard, and that will always be the case.) The pre-seed rounds, the seed rounds — they will find the good teams. If the first move on the chess board was free, it leads me to believe that for most, the second and even third moves will be costly. Those teams will need to demonstrate the ability to attract and retain talent in this inflated, local market; that they can potentially manage offices in different locations to defray costs; that they are masters of their own metrics and cash-planning; that they have found their way into an unbelievably large addressable market; and that they have the credibility to convince larger VC firms that they’re able to go the distance and soar past a billion-dollar outcome — many of the most successful funds have scaled to well over $B and they’re actively seeking multi-billion dollar outcomes to move the needle on their funds. They’ll have to back up the truck for their best companies, take acquisitions off the table, and go right after the incumbents head-on.
Speaking of acquisitions — many leaders of larger VC funds have privately given up on the incumbents buying their companies. Instead, they would prefer to back their winners to take on the incumbents head-on — hence, we have larger funds and longer hold periods to get liquidity. The larger web-scale companies often no longer view startups as a threat — they themselves can absorb large trends and put teams on copying and integrating features.
For those founders who’ve made it to the Bay Area, seed funding is plentiful. Dreams can be fueled here. Downturn or not, the intense competition for local resources is the real drag. Perhaps a downturn will force consumers to tighten their belts, or force companies to be more careful in signing long-term contracts for cloud software. The money for the next idea is already here, waiting; and more money is coming. All the do’s and don’ts of starting up a newco are listed online, ad nauseam, on countless forums across the web. Accelerators and incubators and angels can help new founders get their wings and leave the nest. Seed funds basically exist now to just hand founding teams $3M in one swoop.
I don’t know how I will end this post, because it’s a bit of a ramble. It’s also very focused on the Bay Area, but that’s what I know. I do think a national downturn will hurt funding in other (not all) markets because of the cultural norms around here with respect to angel funding and all the seed funds. And, founders will continue to spin out of the next crop of startups to cross the chasm, like Square, Stripe, Slack, and so forth. Maybe the region will be caught in this perpetual cycle of intense local inflation and an abundance of resources, and the ones who will thrive in such waters are those who, amid all these never-seen-before changes, seize the opportunity that volatility provides. Market volatility may shake loose some M&A departments to be more active, it may give VCs more confidence to attack a sector with a large percentage of their funds, it may empower the founders who can guide others through their own unique maze to see all this uncertainty and volatility around them and harness it to their advantage. You could call this “resourcefulness,” and it’s something I seek out in the founders we back. Hopefully focusing on that attribute will continue to pay off as the next years unfold.