As the public markets have been flashing red lately, my email and DM inboxes have been crammed full of various forms of “What does this mean for early-stage venture investors?” 240 characters won’t do this topic justice, so here are some personal thoughts informed by over three decades of early-stage investing. These comments are from the perspective of an individual investor looking to allocate capital to venture across stages in 2022.
This is not a “crash” or a “crisis”, it is an asset repricing as investors move out of risk-on investments to risk-off investments that will likely follow a familiar pattern. Let’s start with some background, a few things to look out for, and my suggestions for what early-stage investors should do in 2022. Much of this movie is familiar as I have been investing through the last three great asset repricings of 2000-2003 (Dot Com crash – 9/11 etc.), 2007-2009 (The great Financial Crisis), and 2020 (Covid Crash).
Background:
Asset repricing tends to follow a four-step process including:
- Some crazy stuff happens, investors get scared
- An asset class prices collapse, sometimes other assets get pulled in
- Some good stuff happens
- The recovery pushes assets new highs.
Let’s take a look at how this played out in the past as well as where we are at in today’s environment.
It is fairly clear that the public market’s appetite for risk assets has been severely reduced. A few more data points on the current situation from my inbox
- Tiger Global (the largest momentum investor) posted their first down year since 2016.
- IPOs and SPACS post deal as a group in 2021 underperformed the S&P. $10,000 invested in the basked of IPOs for 2021 would be worth $5,500 today.
- An in-process Series B recently was repriced from a $70M raise at $300M post to a $60M raise at $150M pre. Later stage VCs are already adjusting their valuation metrics to reflect the public repricing.
- In Jan 2022 there is an estimated $5T of cash “on the sidelines” which exceeds the $3.9T after the Great Financial Crash of 2009.
- There remains over $222B in VC cash committed waiting to invest including $130B raised just last year.
- Unemployment continues to go down and open job openings are at an all-time high, employees are switching jobs at record levels, we have sector-based labor shortages.
- 2020-2021 has been one of the greatest explosions of company formation we have ever seen.
A couple of things are clear from history:
- 1. Asset Repricing happens in a cycle
- 2. We are in the middle of this one with two steps to go.
- 3. The recovery will come (probably sooner than you think).
- 4. Businesses with good fundamentals, strong growth, and enough capital will be the standouts in the recovery.
Since we are in the middle of this one, let us move on to what to look out for.
What to look out for:
While I am not in the business of predicting public policy, nor the public markets, there are a couple of things (all outside our control) we all need to be looking out for in 2022, including:
What is the “good stuff” that will happen this time?
- Since the Federal stimulus bullets have largely been spent and Washington is gridlocked, I don’t expect those to pull us out, so it is going to have to be a steady economic recovery, no more sudden shocks, and avoiding a recession. If Covid continues to wane, that is “good stuff.” While worry about interest rate increases started this cycle, history shows that assets perform well in a measured interest rate rising environment, so this also could be “good stuff” as everyone gets comfortable with the new program. The other sector to watch is the supply chain that returning to normal would be “good stuff.” If unemployment stays low and we avoid a recession, more “good stuff.”
What, if any other assets will be dragged into this repricing?
- Watch out for the repricing to expand from equities to other assets in 2022. Spreading asset deflation would have the effect a compounding effect on the “risk-off” sentiment causing an even greater wave away from “risk-on” investments. What assets to watch? Housing. Commercial Real Estate. Do not watch crypto, it won’t tell you anything about the real economy where we invest.
Will this repricing slip us into a broader recession (like 2000-2003)?
- The timing of the recovery will largely be determined by if we slip into recession. Primarily watch GDP growth and growth of the sectors you are investing in. Overall, despite the supply chain and covid, the economy has had robust growth. If this stalls, the Fed is likely to slow down interest rates to avoid a recession. We can only hope they get this balancing act correct and we will likely know the result only after the cake is baked.
How long will it be to recover?
- Recoveries have been coming faster with each recent cycle. That said, I expect this one to be a bit more drawn out than 2020 (3 months) and not as severe as 2000-2003. I am not talking about stock market recovery which will be up and down, but the overall investment attitude turning from Risk-off to Risk-on. While interest rates will rise, returns in alternative assets will still far outperform fixed assets and I expect investors to continue to hunt for yield. Keep your eye on the IPO market and growth stocks. While growth has been it hard, growth always has a premium and when the premiums start to return the recovery will be in full swing. If growth stocks get back to the races, so will private market valuations.
Given this environment and the uncertainties of how this cycle will play out the early-stage investor, as always, is best served by focusing on what is within their control. So let’s move on to what early-stage investors should
What early-stage investors should do in 2022.
Momentum investors should slow down their pace significantly.
- I have seen many individual investors playing “follow the leader” behind later-stage leads like Tiger, NEA, Kleiner, for their Series B and later investments. Momentum has even become trendy in ever earlier stages as we have seen with the inflation in YC company valuations. These funds don’t have the same incentives that individual investors do. They have large committed funds, very large portfolios, and are paid large fees to deploy the capital. These funds are the “too much capital chasing too few deals.” While those funds have the capital and portfolio breadth to withstand this current risk-off environment, not many individuals do and individuals are not being paid fees to deploy capital. If your primary investment strategy recently has been “follow the leader”, this will be a very dicey proposition in 2022. Slow down. Become more choosy.
Careful thematic early-stage investors should take a short pause, then put their foot on the gas.
- VC funds raised after a market correction have some of the best returns of any vintage. Some of my own highest multiple investments were made in the teeth of downturns (Amazon 2001, Docusign 2004, FightCamp 2020, etc.). In a risk-off environment, the value of a counterintuitive thesis and Meta Themes that transcend short term market fluctuations become paramount. By shifting asset allocations to earlier stages that fit your themes and being very thoughtful about follow on financings, you can improve the odds of making it through the dip to the recovery phase. As Warren Buffet said, “Be fearful when others are greedy and greedy when others are fearful.”
- In many ways, for early-stage investors, it is back to the basics I have followed for decades: Invest in excellent teams solving big problems in genuinely innovative ways, double down when there is fantastic traction.
Adjust your Liquidity/Round horizons to the mean (from highly compressed).
- When I started investing 30 years ago the average venture company took 7-10 years to go public at a sub $1B. In 2000, I took my company Loudeye public in 4 years at a $2B valuation. Recently OpenSea (a portfolio company) became a decacorn ($14.5B) in just two years. The average Time To Unicorn (TTU) has fallen consistently over the last decade. The time between rounds used to be 12-18 months. One regularly read recently about “hot” companies raising capital every 3-6 months. Lots of money for risk assets has seriously driven up valuations and compressed the time between rounds. While this capital has allowed companies to stay private longer, the repricing of public equities will likely slow the whole train down significantly.
- In 2022 I expect a pause in the train. I expect the TTU to expand for the first time in a long while and the time between rounds to grow as well. While the capital committed to Venture won’t go away, I expect venture investors to get much more discerning, some maybe even pausing. After the DotCom crash, when I was at Ignition Partners, we had plenty of dry powder, but couldn’t get a feel for the direction of things, so I sat on the sidelines for 6-9 months. I moved to New York City and didn’t take any start-up meetings. There is 5-10X more capital sloshing around these days, and I don’t expect such a dramatic pause. Still, I expect a noticeable pullback in the pace of financings and a pronounced elongation of liquidity horizons.
Focus on “over financing” your portfolio, especially those with traction and clear milestones.
- Now, more than ever is the time to focus on capital efficient companies and making sure your companies have sufficient runway. Ideally, a company in this environment should raise 3-4X the capital it believes is required to meet the next financing round (Up from 1-2x). Make sure the financing round you are participating in has clear milestones which will attract the next level of investors. As outside VCs push up the traction requirements for early-stage requirements, I expect to see more inside rounds. Since insiders have more information and tend to be conservative on valuations, these inside rounds can be very good buying opportunities.
Seek out other investors with experience through the cycles.
- There were over 1,000 new VC funds started in the last year, most by first-time managers. There are over 4,000 syndicates on Angel List with most managers part-time and providing very little of their own capital into deals. In a risk-off environment, there is a significant premium for experience through prior cycles. If you are not doing your own primary diligence, make sure someone you trust is. Make sure you understand the meta themes they are following and that you agree with them. Ask more questions, have your own opinion. It is not a time to blindly follow the leader.
What Is Incisive Ventures doing?
We saw this coming and started pushing the pause button in Q4 of last year. While we did 37 investments during the year, we only did 5 (13%) new ones in Q4. In Q1 we expect 1-3 new investments and a couple follow ons of our best companies with the greatest traction. We expect the public market and late-stage valuation pressure to take some time to make its way down to early-stage valuations and we will conserve capital for those opportunities. I expect to see fewer, but more opportunities like Tradewell (low single-digit pre for a revenue-generating product). We will over finance those in our portfolio with great traction like Katalyst.fit (recently raised $22.5M Series A).
While we have yet to see any write-offs in our AL portfolio, depending on the length of this correction/pause and the strength of the recovery I would expect portfolio companies without significant traction to face a very tough fundraising environment in the near term. I would expect more follow-on financings to fail our follow-on investment test in which case we will not invest, nor send them to the syndicate. We do not expect to participate in every follow on financing this year.
As early-stage valuations hopefully soften and opportunistically in high traction companies, we will be pressing our foot on the gas. Given a large amount of cash on the sidelines and the massive amount of pent-up venture capital, I would hope to see this as soon as the second half of the year.
We have over 50% of the IV AccessFund I, where I am the largest LP, left to deploy. We will be closing Access Fund 1 in Q2 and moving on to Access Fund 2 in the second half of the year. If you are an accredited investor and want to join the fund, please do so soon.
Overall, we will remain, as always, Incisive.
Summary
No, the sky is not falling. We are in the middle of a familiar asset repricing cycle. While there are many unknowns and more craziness certainly can happen, the advantage in these cycles goes to the careful thematic investor with enough dry powder. We believe our Incisive approach will produce superior returns through this cycle as it has for me over the last couple of decades.
