Letter to a Young Investor*
Dear X,
In times like these you likely find yourself one of two minds: this is the crisis you’ve been dreading or the crisis you’ve been waiting for. The actions you now take, or refrain from, will depend on the health of your current portfolio and the health of your fund, and unlike previous crises, also the health of your person. All things above being equal, I will attempt to provide some advice as to how you may approach investing in the current environment and fulfill your role as a venture capitalist.
Short-term Macro-trends Were Never Your Barometer
Let’s start with those of you who think the end is nigh. It admittedly requires some cognitive dissonance to take in the newspaper headlines in the morning and contemplate new investments in the afternoon, but I will remind you that your job as a venture capitalist is to focus on long-term trends and long-term financial results. You can afford to take risk today because of the low probability of aa huge payout in the distant future.
All venture capitalists declare themselves to be long-term investors and take pride in being patient capital. This platitude was hardly challenged as long as one could reliably count on rapid valuation appreciation and cheap follow-on capital in the short term that never seemed to dissipate. Long-term investing, however, mustn’t assume these short-term dynamics persist indefinitely. And as you see now, everything has flipped. Once confident in your ability to predict revenues three years out, your portfolio companies can’t even forecast the next quarter. It sounds intimidating, but in truth long-term investing was always about having greater confidence further out than in the immediate future.
A commitment to long-term investing should not come with a macro-economic caveat. Headlines and engaging graphs can certainly inform your investment decision, but should never determine it. You didn’t quiver at the thought of competing with a mercurial juggernaut armed with a $100B growth fund yet now shudder at the prospect of 20% unemployment or a 50% decline in stock market indices. Venture capitalists don’t justify their investments on positive macroeconomic indicators like low unemployment, favorable GDP forecasts or rising stock market indices. That’s because venture capitalists don’t bet on the trends that grace our mass market newspapers or cable news chyrons, but on those trends that are initially too obscure to be named, let alone to warrant a headline. To that end, a successful venture capitalist will take pride in having done something to make the news (vicariously of course), not in simply reading about others who’ve made the news.
“The fact is that recent economic numbers have been terrifying, not just in the United States but around the world. Manufacturing, in particular, is plunging everywhere. Banks aren’t lending; businesses and consumers aren’t spending. Let’s not mince words: This looks an awful lot like the beginning of a second Great Depression.”
The quote above comes from New York Times columnist Paul Krugman on January 4, 2009. Reporters are best at reporting what already happened; much less so about what will happen. I would say the same about economists and a bunch of other professions that are never made to entirely account for their forecasts. However, you have chosen a profession in which you are paid to make perceptive bets on the future, especially those that others will dismiss and ridicule, and in particular in times of turmoil and uncertainty. You put your reputation, time and money to work to help realize that future and expect to pay a price when you’re wrong.
I don’t know how long or deep this downturn will be, but rest assured it will be one for the history books. I’ll simply remind you that the sole cause for the economic decline has been genuine concern for our health and it will likely be the emergence of a viable health solution that will be the trigger for the economy’s inevitable return. Unlike previous economic crises, this was a planned, organized shutdown by governments around the world with massive fiscal stimulus packages already underway. Although there will be lasting damage, there is still a reasonable case that the recovery could also be among the fastest we’ve ever experienced. Waiting to find out won’t earn you any awards. Time diversification is a real thing in venture capital, including during periods like this.
The Future Was Never as Bright as You Thought it Was
The dreams of exponential growth that once got you out of bed in the morning now feed the nightmares that keep you awake at night. The credulity of venture capitalists in the exponential excel models produced by startups has simply been replaced with the exponential excel models of epidemiologists. Venture capitalists appreciate the power of the exponent better than most, but we also know through experience that exponential growth cannot continue indefinitely without considerable and consistent intervention, stimulation and investment. And right now, the world is working furiously to frustrate the ominous projections of epidemiological forecasts.
This is why I won’t trust an epidemiologist’s predictions any more than that of the weatherman or the early stage entrepreneur. They are often directionally correct, but almost certainly wrong in so many other ways as they rely on too many dynamic inputs. This is not to say the worst forecasts won’t come true, only that we don’t know that. Nor do we know the ultimate impact on the economy, let alone the impact on a small startup addressing an infinitesimal slither of the global economy. As reminder, all you need is for the small market trend you’ve already identified to continue its growth in spite of, or because of, the chaos around us.
Venture capitalists may not share the ebullient optimism of entrepreneurs, but we are fundamentally optimists and strong believers in the power of innovation and the general march of human progress. So have a little more faith in science, medicine and technology. Perhaps not tomorrow, but 12–18 months from now. Show a little more appreciation of the ability of humans to quickly adapt to hardship, respond to necessity, improve their lot and fulfill their desire to live life! And discover in yourself the same resolve that your entrepreneurs are demonstrating this very moment. Surely you don’t think fundamental technology change would only happen when cash was plentiful and forecasts unimpeded.
As unnerving as it is, this crisis is unlikely to reveal any fundamental flaws or weaknesses in most of the technology trends being pursued by venture capitalists. On the contrary, all indications are that the adoption of technology will strengthen and hasten as a result of this crisis. The businesses that are surviving the current shut down amid shelter-in-place restrictions are doing so thanks to technology adoption that made it easy to enable remote work and straightforward to connect and transact with their customers and suppliers online. And as the economy begins to recover, the winners will be those businesses that embraced technological change even during a downturn.
You are in an enviable position because you have more time. Time to work with the companies through an uncertain period. Time to prove your sage decisions. Even time to experience some disappointment and failure without letting it unsettle you. Three years from now when you look back, you will realize the biggest investment mistakes you made were in the 12 months preceding this crisis, not in the first 12 months following it.
Take your time but be resolute about finding your sea legs. A macro crisis is an opportunity, and a terrible one to waste for the young venture capitalist. This is where you as an investor can shine and make your mark, not because you ignored the world surrounding us or the heightened risk that abounds, but because you figured out how to manage the risk while seizing the opportunity.
Erase That Gleeful Smile
Whether or not I have you reconsidering the apocalyptic mindset that momentarily arrested your ability to think long-term, I must now address the more sanguine among you. Those among you who eagerly awaited a downturn, anticipating suddenly reasonable valuations, less competition and a free run at market dominance for the startups you decided back. I have some advice here for you too. You may not cower in the face of the relentless stream of bad and upsetting news, but you cannot pursue the same investment strategy that served you reliably until now.
Things have changed — and not just valuations. There will be much less follow-on capital. You will lose confidence in forecasts. There will be less room for a niche player to make it big. You will have a harder time taking comfort in investment herds and will need to acquire the confidence to become an individual deal picker and contend with being labeled a “contrarian.”
In times of macro-economic shock, venture dollars that continue to be invested should ideally flow to capital-efficient businesses that can show healthy growth in the recessionary environment and that promise accelerated growth in a recovery. What constitutes “healthy growth” and “capital efficient” in the new environment will vary across market segments and stages, and it’s up to you to determine.
For obvious reasons, you should avoid the high burn businesses that subsidize their customers to create demand, but you can expect to see fewer such opportunities anyway. You should also avoid the temptation to invest in startups suddenly enjoying their day in the sun courtesy of the current environment. It is fantastic that the current environment can serve as an accelerant to a startup’s existing growth, as long as this aberrant environment is not a substitute for a genuine growth plan.
The venture time horizon extends far beyond the current crisis, which means you still need to back strong teams with a highly differentiated offering and long-term competitive advantage. This can be challenging because certain trends are experiencing a remarkable, yet short-term, boost that will be difficult for most startups to exploit long-term, such as work from home tools and online education services. To be clear, there is a compelling long-term trend of remote work and online education, but the extreme spike in demand some companies are experiencing likely obscures the true underlying market demand as well as those companies best positioned to win long-term.
Compelling opportunities are likely to appear in previously stubborn markets that have resisted fundamental technology change for too long. The crisis may dislodge whatever was blocking technology adoption, forever altering the trajectory of markets such as telemedicine and other types of business infrastructure and service modernization. This may not immediately manifest in short-term sales growth for these companies, but rather in improved pipelines, shortened sales cycles and faster and bigger rollouts. Therefore, investing in such opportunities today would be centered on the assumption that, as a result of the current crisis, the startup can more effectively sustain growth following the conclusion of the crisis.
It will be up to you to determine price, but this will likely prove be more frustrating than it appears today as the best companies will continue to be price makers and not price takers. This means you should still be prepared to pay a premium for the best opportunities. Some hesitation is to be expected, but it should not send you in the opposite direction, namely looking for low valuations. Be wary of such “value” deals, whose chief investment merits are expressed in an attractive price for you and onerous terms for existing shareholders. A crisis is a terrible opportunity to waste, but it is still a crisis, so adjust your sights and expectations accordingly.
Maintain Your Composure
Regardless of your current mindset concerning new investments, new pieces of information can still invert your thinking overnight. It’s only natural that your confidence level goes through ups and downs in a chaotic environment like this, but a successful investor doesn’t let every short-term data point disrupt his or her focus on the long-term.
I have deliberately been non-prescriptive with my advice, as only you can determine what investments are right to pursue and how to pursue them. But I’ve hopefully provided a framework to begin to think about new investments and not just portfolio triage. I needn’t remind you of the numerous great companies that were founded and funded in previous times of crisis. You aren’t a venture capitalist until you’ve weathered a crisis and found a way to pursue opportunities in the midst of a storm. I look forward to hearing about your first investment in this new era. Welcome.
*A young investor is any venture investor who was not in the business in the crises of 2008 or 2001
