On early-stage venture’s time to shine
Amidst a global pandemic causing a saddening loss of life, skyrocketing unemployment rates and global markets in turmoil, it’s difficult to find optimism. But as a 20+ year technology entrepreneur and investor, it’s my nature to be optimistic, and while I’m terribly pained by all the suffering in the world right now, I’m also excited about the role that startup investors like me will play in its recovery.
In my previous post I spoke to why startups thrive in times of upheaval and how they can help lead the world out of this crisis. Today I’d like to zoom out and talk about why those who invest in these startups, early-stage venture investors, are able to give provide them with the rocket fuel they need while earning great financial returns for our own investors.
For the uninitiated, there are two main types of early-stage investors: individual angels and seed-stage venture funds. Angel investors tend to bow out during times of crisis, in part because they have less capital to invest as their public equity portfolios decline, and in part to refocus on what they feel are safer assets like bonds, gold, and cash. So, this post will focus on the folks who can keep investing in startups during times of crisis and recessions, seed-stage venture funds like Rebel.
Here are the main reasons it’s good to be a seed-stage venture fund right now:
#1 — There are more great startups
While nobody knows exactly how many startups there are in the world, Y Combinator is often considered a microcosm of the startup landscape overall, and as you’ll see below, the number of YC companies has been steadily rising.
What’s more, the number of people starting companies always goes up during a recession as people get laid off from their jobs and look for other things to do. Little known fact — I started working full-time on my first startup when I was laid off from Bain after the dot-com bust in the early 2000’s.
While we’re yet to see how many new entrepreneurs this current economic crisis will mint, I’d expect it to be many millions.
#2 — There’s a 30% off sale
As a venture fund manager, I’m fortunate to have a dedicated pool of capital that allows our fund to continue investing regardless of market conditions, and thus be opportunistic when the price of the assets we invest in — technology startups — suddenly declines.
Startup valuations tend to move in the same direction as public company valuations, but more extremely. As you’ll see below, startup valuations have been rising dramatically in recent years at all stages, much to the dismay of investors, but I’ve seen valuations drop 25–30% in recent weeks and expect further declines in the coming months.
This means that early-stage venture investors are able to buy larger equity positions in startups at any given dollar amount, thus increasing our investment returns when we sell those positions at exit.
“But aren’t exit valuations also impacted during a recession?” you might ask.
Yes, but that’s a problem for late-stage venture investors, not early-stage investors like us. We typically hold an investment for 3–5 years before exiting, allowing plenty of time for valuations to climb back up before we sell.
#3 — There are new problems to solve
Early-stage startups, and by extension those who invest in them, tend to thrive during times of upheaval. The reason is that rapid change always creates a new set of problems, and nobody is better equipped to solve these problems than nimble early-stage startups.
A familiar example of this is the Y Combinator-backed startup Airbnb, founded in 2008 in the depths of the Global Financial Crisis, when millions of American households were desperate to make money and save money however they could.
Airbnb brought people the ability to earn significant income by renting out spare rooms in their home and save significant expenses while traveling, but only if they could get comfortable with the ‘radical’ idea of homesharing with strangers. I doubt that early customers would have taken a chance on this idea if they weren’t in financial distress.
The rest is history:
The coronavirus crisis will not only help a new generation of pro-recessionary startups like Airbnb get off the ground, but will also give rise to a new generation of startups creating software, hardware, and biomedical solutions geared towards fighting this virus and infectious disease more generally.
Just in the past week, I’ve met with startups doing the following:
- Helping airports identify sick passengers using IR cameras and AI
- Developing high-volume/lost-cost Covid-19 antibody testing using saliva
- Training newly unemployed workers with today’s most needed trade skills
- Crowdsourcing the most effective Covid-19 treatment ideas
- Matching up funded Covid-19 research projects with the best scientists
The world needs innovations like these now more than ever, and smart and passionate founders are bringing them to market as we speak.
#4 — There’s less competition
This is the main reason for declining startup valuations, but it has other benefits to early-stage investors as well.
In the last downturn, deal volume fell at every stage of venture investing except seed (which I believe would have fallen as well if it wasn’t in the midst of a growth spurt as a new asset class).
Less deals against the backdrop of more innovation means much less competition from other investors, thus shifting the balance of power from founders to investors. This means greater choice and more favorable deal terms for the investors who remain.
While less cash moving around the venture ecosystem isn’t good for founders, which does pain me, it’s great for those investors who stay in the market.
#5 — Existing technology trends are accelerated
Every startup’s greatest nemesis is the status quo, and times like these leave the status quo in ruin.
In his 2006 classic Crossing the Chasm author Geoffrey Moore explains the technology adoption life cycle.
Every new technology must fight its way up and over this curve, and certain types of crisis can greatly accelerate their progress. A few existing technology trends that I’ve seen accelerated by the coronavirus crisis include:
- Video conferencing
- Telemedicine
- Remote education
- Mobile apps
- Ecommerce
- Biotech
While public companies like Zoom, Amazon, and Etsy are the most visible beneficiaries of this phenomenon, many private technology companies in certain sectors are also seeing massive growth in adoption that will likely persist long after the current crisis has passed.
#6 — Early-stage startups (and funds) can pivot
I made the statement in my last post “While Delta can’t be anything but an airline and Hilton can’t be anything but a hotel chain, a startup can be whatever it wants.”
This is illustrated in a recent startup founder survey by our friends at NfX that found 36% of startups are already pivoting their product due to this crisis and that 62% of these pivots are moderate to significant.
What this means practically is that many startups who didn’t have a pro-recessionary or pro-crisis business model a few weeks ago, now do. At Rebel we’ve already seen dramatic pivots in our own portfolio, inspiring examples of how flexible and adaptable founders and startups can be.
This applies at the venture fund level as well, at least for those who are early in their capital deployment cycle and have broad, industry-agnostic investment mandates. Such funds can quickly ‘pivot’ their portfolio to focus on startups that are optimized for a post-covid world.
#7 —Early-stage venture tends to be pro-recessionary
In the heart of the Global Financial Crisis, venture returned a 11.36% IRR to investors in 2008, a year when the S&P 500 dropped by -38.49%…
…in fact, a premier venture capital fund-of-funds, Top Tier Capital Partners, reported that their best-performing venture fund investments were made during the GFC years.
Venture capital is also pleasantly non-correlated with other asset classes that are disfavored right now…
…and history shows that small venture funds tend to outperform larger ones...
…and early-stage funds tend to outperform late-stage funds.
So if you add it all together, right now is the perfect time to be an small, early-stage venture fund, especially one early in its capital deployment cycle with a broad investment mandate.
I feel fortunate to be in a position to provide capital in the coming years to some of the many technology startups that will lead our way out of this crisis, while helping to create incredible value for their founders, employees, and my fund’s investors in the process.
