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September 1, 2023

Thoughts on the turbulent venture capital environment

By Evli Growth Partners

The timing of my first steps in venture capital could not have been more interesting: I have gotten to witness a notable market slowdown after the “fund anything – anyhow” boom bust late last year, where now some people argue for a transitory hiccup in funding activity while some go as far as declaring death for the industry. The jury is still out on how the situation will exactly play out, but as it often is, the outcome likely lies between the extremes.

What is hard to disagree on though is that venture capital, like almost every asset class out there, is not immune to economic cycles. Drawdowns are bound to happen from time to time when the market becomes too hot. However, instead of sitting hands-tied waiting for the next bull market to come around the corner, I would like to view the ongoing period as an opportunity for both entrepreneurs and venture capital investors to reflect and take some valuable lessons with them when the ride goes up again.

A true test of entrepreneurship

Taking the risk of sounding cliche here, but tougher times truly create business champions. What we see now is that, after a while, companies’ business models are under scrutiny and metrics other than growth rate have become important again. Companies with high burn rates must take action to survive since investor tolerance for cash burn has reduced and income financing for these companies is not an option. Funding is scarcer (or at least more selective) again, and companies must make the best out of the resources available.

In other words, entrepreneurs are now forced to make business decisions that enable a healthy base for the business to thrive in the long-term. This could prove advantageous though: cementing financial and operational efficiency in the company’s DNA from early on can be a powerful force in the future when the dust settles again. Some well-known living examples of this are Square, Slack, and Airbnb, all of which were founded during or in the aftermath of the 2007-2009 financial crisis. Surely less competition and better access to talent in a recessionary environment were important contributors to their success, but I believe early adopted financial and operational discipline were at least equally important factors.

The unfortunate but natural flipside of the tightening funding criteria is it may signal death for some companies with poor unit economics or those that have not found a solid product-market fit to build upon. An inevitable reality check and thus restructuring are ahead for many business models that do not match the current investor appetite.

Nevertheless, I believe entrepreneurs should consider this current “nudge” to think for the long-term instead of maximizing growth percentages for annual financing rounds a valuable investment for the future. As we have seen in public equities, the best business leaders place very little weight on quarterly earnings, but instead rigorously monitor that the company is executing according to its long-term strategy.

We should believe scratching out the long-term playbook with the resources available will bring the best out of entrepreneurs and entrepreneurship.

Venture capital investors cannot stop making risky bets

For VCs, on the other hand, little has changed fundamentally. On the operational side, deal due diligence will have more emphasis again and better capital efficiency is expected from companies. In my view this is hardly a change, since the heart of our investment philosophy at Evli Growth Partners could be simply defined as common sense investing: we want to see a sensible business model operating with healthy unit economics.

As we know, this was not a requirement to get funded in the final stages of the recent bull run. The cost of money was zero, and investors threw money at hypergrowth companies whose seemingly excellent traction figures may only have been due to the superior sales strategy of selling a dollar for 90 cents. After such a period where companies were rewarded no matter how poor their decisions were, you would think most investors welcome some common sense back in the market with open arms. Even better, if history rhymes and the stretched valuations eventually follow the path of the public market, VCs should embrace the opportunity to buy quality businesses with justifiable prices again.

Most importantly though, the very investment thesis of venture capital remains unchanged. A small portion of the investment portfolio is allocated to venture capital hoping to uptick returns and earn some diversification benefits on top of that. To earn those high returns, VCs are expected to invest in a number of high-risk ventures from which only few will pay off big. As most of the returns are driven by these few big wins, the dispersion between the top and bottom venture fund performance is notably large. Selecting the right fund to manage your money thus becomes a crucial decision when allocating money to venture capital.

What this means for VCs is that consistently making bold, risky, but justified bets in their own areas of expertise makes it possible in the first place to catch one of these big winners. There will always be extreme uncertainty in venture investing, however, if even the small odds of hitting big fade away due to becoming overly cautious in bet selection, the case for a venture capital investment can be compromised. Some could even say the asset exposure could and should then be replicated through small cap growth stocks instead.

As Sequoia Capital’s Doug Leone well put it, venture capital is a dreaming business with entrepreneurs:

We do not want to lose ... our true belief to align ourselves with you and to dream with you — I think we lose that and we’re out of business”

This points to the bottom line that despite the turbulence in the current venture environment, the big picture remains the same for venture capital investors. They must continue making risky bets.

Why?

Because risky bets keep them in the business.

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