Sequoia, at least according to Charlie Munger, have one of the best investing track records in history. The presentation also pointed to several public market reference points to warn its companies of the dark clouds ahead.
The Nasdaq’s 28 per cent fall is the third-worst drawdown in 20 years, but the pain was most acute in non-profitable tech companies that fell by twice as much.
Almost two-thirds of software, internet and fintech stocks were actually below their pre-pandemic levels.
Investors no longer reward growth at all costs. Tech company multiples of enterprise value – the sum a company’s debt and equity – to revenue have halved from 12 times to less than 6 times, which is the ten-year average.
The cheap money was no longer coming to the rescue. One of the disputers of venture investing has been Tiger Global. The fund manager took a spray and pray approach to investing by being first to cut a cheque to firms raising money.
But these hybrid hedge funds are now impaired because massive declines in their public holdings have left them relatively over-exposed to private investments, and that means they simply can’t cut more cheques.
The overall message from Sequoia was not to be in denial and for founders to put their game faces on and be prepared to make tough calls as a bleak period approaches.
“Don’t view a cut as negative but as a way to conserve cash and run faster,” it said.
Street on the same side
In Silicon Valley there does appear to be some consensus on this issue. Another esteemed firm Y Combinator also sent a letter to its portfolio companies titled Economic Dowturn that could be summed as: assume brace position.
“Regardless of your ability to fundraise, it’s your responsibility to ensure your company will survive if you cannot raise money for the next 24 months,” read one of the points in a report by Tech Crunch.
Justin Kahl and David George of another storied venture firm Andreessen Horowitz shared a similar sentiment in a recent blog post titled A Framework for Navigating Down Markets.
The aim was to give advice that went “beyond platitudes” of conserving cash, extending runways and shifting away from focusing on growth to being more efficient.
But the examples they give are pretty terrifying. One is of a company that raises money at a $2 billion valuation that had an annualised revenue run rate of $20 million.
It’s not a good look to raise money without a year’s worth of “runway” nor is it great to raise money at a lower valuation. So, what would this business need to do to maintain that valuation?
Well, public markets now value similar businesses at 10 times ARR (versus the last raise at 100 times) but if it is growing fast, it might be able to command a multiple of 15 times.
But even then, it would have to lift its ARR by almost seven times to $133 million whilst maintaining enough money to last a year. Simple!
Then there’s the cash burn. Andreessen Horowitz prefers to measure cash required to generate a dollar of revenue compared to the costs of customer acquisition that tend to only measure sales and marketing efficiency.
For this fictional company, the venture fund’s historic tables suggest that this $2 billion company must spend less than a dollar to drive a dollar of sales otherwise its in trouble.
The cash burn should fall as a company gets bigger and achieves greater scale. But it’s a tough balancing act to maintain access to capital as multiples have collapsed while keeping costs in check.
While some firms will adapt, survive and flourish, the gravity will surely catch up with a wave of start-ups that were force-fed cheap money. That might be why venture funds are preparing for a period of pain.
Spare a thought for these fearless founders, who were told by their backers to do think big over a long time horizon or face extinction, but are now being told their survival is at stake.
If they haven’t learnt by now, private markets aren’t too different from their manic public equivalents.
Those that respond quickest to its rapidly changing signals will be rewarded, while those fail to adapt will be punished.