How Venture Can Survive and Even Thrive in Recessions - Part 1

Despite Wuhan being in lockdown, I believed that a single-party system built on misinformation was not going to be able to contain a virus that was more contagious than SARS — and in a world that was far more interconnected than ~20 years ago. China’s problem was soon to be our own.

The realization brought me back to experiences of past downturns. I remember March 13, 2000, like it was yesterday. On that day, it became clear that the NASDAQ frenzy of mass speculation in internet-related companies — the so-called dot-com boom — was a bust. While tech companies took months to break out of their stupor of denial that the party was over, the recessionary effects rippled to other industries.

In 2008, our financial markets wobbled with the bankruptcy of Countrywide, but it was Lehman’s white-knuckle collapse in September that defined the Great Recession. What was initially thought of as a Wall Street problem quickly became a Main Street problem.

Today’s world is even more hyper-connected. Tight linkages in capital markets, supply chains, and commerce mean recession in any major economy tends to affect us all. Which leads me to my second point: When we’re faced with recessions, emotions tend to run high. During these emotional times, separating fact from fear is essential.

Factually, we know a couple of important things. First, the U.S. has experienced three recessions since 1990, and the average peak-to-trough contraction took just over 11 months, with recovery taking many months thereafter. This would suggest we are destined to a downward slope well into 2021. However, the Federal Reserve is behaving in truly unprecedented ways, using all of its firepower to instill confidence and unleash liquidity to stave off bankruptcies and encourage employment. So, what’s going to happen next?

The truth is, no one knows how the economy will perform in the short term. But to the venture investor, the short term is much less meaningful than the medium-to-long term from which investment outcomes are generated. Through this lens, whether the recession has a “V,” “U,” or “L,” recovery matters much less than knowing that there will be a recovery.

And recover we shall. For well over 100 years, it has always been a good investment to bet on the vitality of the US economy. Innovation is its engine room. For half a century, sophisticated venture investing has been a key driver and recipient of the benefits of American innovation. The returns of top-quartile venture firms — with which AVG strives to invest — have outperformed those from all other asset classes.

So, whether the recession is long or short, deep or shallow, playing the long game has and will remain a sound investment choice.

How COVID-19 Is Different

Unlike during past disruptions, the U.S.’s healthcare situation must stabilize before our economy stabilizes.

As of mid-April, some 86 candidate vaccines and experimental compounds are being evaluated or are in clinical trials to fight COVID-19 (many of which are being backed by venture capitalists). It’s hoped that therapeutics will arrive within months and a vaccine in 2021.

As the risk of infection subsides, consumer confidence will rise, and what is likely to start as a slow recovery will accelerate. Until that time, we must identify infections quickly, isolate them, and then trace their source. Simple concept, herculean execution.

Paradoxically, it was government-mandated shelter-in-place policies — appropriately issued to protect the health and safety of millions — that has led to the stratospheric surge of Americans seeking unemployment benefits. Small businesses, including venture-backed companies, account for nearly 50 percent of private-sector employment in America. In these unprecedented times, to keep a company afloat means the near-immediate cutting or furloughing of employees — gut-wrenching but necessary decisions.

Take comfort in knowing that conquering COVID-19 is the world’s collective number-one priority. COVID-19 too shall pass.

What COVID-19 Means for Venture

There is a belief in venture that every 10 years or so business models are forced to refocus on the quest for rational profitability (product-led growth), and the reckless pursuit of customers (dollar-led growth) becomes passé. As Alfred Lin of Sequoia has noted, the “fear of missing out” has given way to the “fear of looking stupid” among investors. We seemed due for a pullback.

Indeed, markets were already adjusting following the WeWork debacle in Q4 2019, where the number of big funding rounds — those over $100 million — had already fallen by a third. The companies that wrote many of these checks allowed undisciplined firms to avoid the scrutiny of the public markets and have since been punished. Speculation, often seen at the tail end of long booms, finally gave way to substance.

Sequoia followed its now-famous “Rest in Peace Good Times” presentation from 2008 with a letter to founders and CEOs calling COVID-19 the Black Swan event of 2020. Sequoia, like so many others, has tightened its investment criteria and is encouraging its portfolio companies to tighten their belts by

• Extending cash runways
• Planning contingencies based upon the market environment
• Conducting only mission-critical projects
• Raising the ROI bar on marketing spend, and
• Doing more with less headcount

— to name a few strategies.

There is no escaping the need to adapt in response to COVID-19’s impact. Every venture capitalist is being forced to triage their portfolios against recessionary vulnerability (impact on cash, capital raising plans, burn rates, revenue projections, budgets, etc.), as well as the specific threat of COVID-19.

Investments that bring people together in the real world — those with business models that support taking trips, eating out, staying in hotels, going to the movies, retail shopping, or generally gathering — are most vulnerable. Tempered, of course, by a bullet-proof balance sheet.

Investments that provide access to remote healthcare (telemedicine, direct-to-consumer), generic consumer staples (food and its delivery, toilet paper!), or services for those stuck at home (entertainment, e-commerce), are well-positioned. In short, across the world, demand is shifting online at an accelerated rate.

Today, VCs are still open for business and doing deals, just more slowly and selectively. They are backing teams with both clarity of purpose and track records of success operating in capital-scarce environments. Investment terms are changing too. What has largely been an environment of management-friendly terms is giving way to reduced valuations, inside-led rounds, smaller rounds, and downside protections for investors. For smart venture investors, that’s an opportunity.

What COVID Means for AVG

In both good and bad economies, the fact that Alumni Ventures Group is not a typical venture capital firm works to our advantage. First, we’re different in that AVG is strictly a co-investor, seeking to invest alongside proven venture capitalists under equivalent terms. We don’t sit on boards or negotiate terms or governance. We look to be helpful to every team we back and every VC we partner with.

Our base is also much broader and more deeply connected than that of a typical venture firm. We are a network of 16 alumni funds and about 50 investment professionals. Most importantly, we are a community of 500,000 — entrepreneurs, investors, and others — who are disrupting the status quo to build a better future.

In times of adversity, when social mistrust runs high, alumni communities draw people closer together. In my own community, I was deeply moved by the note of gratitude from Lawrence Bacow, President of Harvard. Both he and his wife had been “laid low” by COVID-19. There is something intrinsic about your alumni community, a time forged by youth and shared experience.

Over the last five years, AVG has invested in more than 450 companies alongside 130+ established VCs. Access to these investments has almost universally been a function of portfolio managers, portfolio customers, or the VCs involved having gone to one or more of the universities represented in our alumni communities.

Our connections run deep — and all to the good in this era when social distancing forces business to be conducted remote. This makes venture investing enormously challenging. Truisms in venture are to chase your winners and for the next round of funding to be led by fresh capital — an arm’s-length, experienced, and trusted venture capitalist. It’s that lead’s responsibility to set valuation, terms, governance, and other important operational matters.

In today’s environment, however, it’s nearly impossible to conduct proper company, market, and customer diligence. Zoom calls do not cut it! This means the best deals will be funded by “insiders” and by those where trust and relationships matter more than usual. It’s almost as though AVG’s unique community-based model was built for this moment.

Do not mistake AVG’s investment volume or co-investing strategy as indications that we are not diligent. On the contrary, we are a process-based and highly disciplined investor, with numerous checks and balances and a rigorous scoring methodology to leverage the wisdom of our seasoned teams. We are also very much cognizant of changed circumstances. Almost overnight, the cost of capital dramatically increased for every company in the country. Fortunately, our wide-reaching community and resilient capital base has afforded us an unparalleled advantage as a co-investor in a downward-trending market.

What AVG Is Doing

AVG takes the long view, and our investment strategy does not change with market cycles. COVID-19 has only heightened our resolve to execute upon solid investment fundamentals:

• Portfolio first: Some of our companies will need additional financing, and we will look to lean into our winners.
• New investments: We will redouble our efforts to access quality investments, led by management teams who have experienced market cycles and are backed by steady and well-capitalized VCs.
• Lead investor conviction: We will look for rounds ideally led by the conviction of outside fresh capital or trusted insiders with aligned interests.
• Runway: With capital becoming more selective, we will look to back entities with long operating runways, demonstrated capital efficiency, and realistic fundraising plans and revenue forecasts.
• Line of sight: In this uncertain environment, we will look for management teams that are clinically realistic, focused, and able to manage conflicting information to execute measurable business milestones.
• Unique terms: In addition to lower valuations, we will look for seniority in capital structures and other protective terms to ensure that our investors are protected in a downward trending environment.
• Exit strategy: Even viable public listings are on hold, but consolidation by the well capitalized will accelerate as due diligence becomes more feasible.

The key points are to remain disciplined and judicious in how we invest our capital and how we build our companies for enduring success.

Beyond COVID

As venture capitalists, we strive to make the world a better place. Even when billions of people are on lockdown, human ingenuity never stops inventing. More than ever, the dreams of entrepreneurial people today are wrapped up in the hopes of growing a business to solve some of the world’s most intractable problems — which the response to COVID-19 has made abundantly clear. AVG aims to help.

While it’s difficult to contemplate life after COVID-19, it’s clear that things will never go back to “normal.” Some of the largest venture funds in the U.S., including NEA and Lightspeed, have just closed on mega funds to tap into the market disruptions that lie ahead. In all adversity, there is opportunity. In fact, the best-performing vintages tend to be those which invest at the bottom of a recession and into the early stages of a recovery. During this time, valuations are lower, management teams are more resilient, startups are more frugal, and revenue lines become propelled by macro tailwinds.

The magnitude of market changes over the next 18 months will be profound, and the opportunity for the nimble, brave, and creative will be colossal. What are the social and business changes we can expect to see over the next 3-5 years? What might consumers value? Where will there be structural change? What new companies will emerge?

We don’t have all the answers, but what is clear is that the shift to digital-everything has been amplified for individuals and companies alike, and adoption of new technologies will be quicker. Listed below are a few trends and ideas that AVG sees proliferating:

• Cloud: Movement to cloud computing and storage will accelerate, making applications and data more accessible — and at a lower upfront cost. After all, nearly half of humanity carries a smartphone in its pocket, creating reams of daily data.
• Robots: The move toward automation within old-school and e-commerce pick-and-pack warehouses, last-mile delivery, and even vertical farming will muscle out low-skilled labor.
• Supply Chains: Supply chains will be redesigned to offer more flexibility and redundancy, so that they can be maintained globally or closer to home.
• 3D Printing: There will be a surge of local, tech-driven manufacturing to ensure businesses are self-sustaining.
• Independence: As people grow more aware of our global interdependence — and the accompanying risks in a climate of international crisis — more companies will focus on energy and food independence.
• Future of Work: Alan Jope, CEO of Unilever, a consumer goods behemoth, recently called remote working “dead easy” for his workforce of 155,000, ordering his sales teams to sell virtually. Jope, among others, has made clear that the long-term effects on the workspaces of existing businesses will be dramatic.
• Distributed Structures: Many early-stage companies begin their journeys in a distributed fashion to save on rent and wages, and engineering “teams” are often a disjointed group of remote workers — the new norm. Digital tools like Slack for messaging and Zoom for videoconferencing are only the start of the tools that will emerge to facilitate open-sourced and fully distributed organizational structures.
• Public / Private Partnerships: With insufficient global coordination by governments and NGOs to conquer COVID-19, the private sector will become a necessary part of any solution. Companies of varying shapes and sizes will learn to turn the U.S. government into a key ally and customer, as the government will become the engine of consumption.
• Data and AI: AI, ML, and facial recognition will take giant leaps forward as consumers relax their personal privacy concerns to avoid exposure to the virus behind COVID-19, sharing their data with blossoming public/private partnerships.
• Voice Everything: To avoid the spread of germs, the world will become increasingly touchless with voice recognition, biometrics, and magic passes moving to the mainstream. Digital and mobile payments will get a huge boost from consumers.
• Virtual Learning: With colleges and possibly other educational institutions across the country having to plan for the possibility of remote classes in the fall, all families will open up to new ways of learning, skill development, and peer-induced exercise.
• Virtual Connectedness: Humans are social creatures, and whole generations that were previously reluctant to try something new — Baby Boomers and even Gen Xers — will find that they actually enjoy virtual wine parties. Virtual connectedness between friends and family will become the norm, regardless of distance.
• Healthtech and Biotech: Large and small companies will drive progress in myriad ways as people increasingly embrace healthcare at home, telemedicine, and sharing health records. Tech wearables will be perceived as a small price to pay, first to avoid COVID-19, then to supplement a host of other therapies, leading to improved individual outcomes.
• Recurring Revenue: After watching revenue evaporate at breathtaking speed, all companies — but especially subscription-based companies — will attempt to build more sticky and predictable revenue streams.
• Entertainment: Movement to at-home entertainment will accelerate, and virtual reality will find its moment both inside and, more importantly, outside the home.
• Online Security: As an increasing number of people begin to work remotely, online devices will proliferate, exposing corporations to malware and increased vulnerability. Strained budgets will make room for security.

Those are some of our predictions at AVG. As venture investors, we have the job of watching the near- and longer-term horizons for changes. Like explorers of days past, we’re in uncharted waters. Storms and unforeseen reefs will surely appear, but spectacular vistas and new lands will present themselves as well. Creativity is limitless, and the human spirit indomitable. Despite — and, in fact, because of — all this adversity, now is a good time to be investing in venture.