One of the values that I’ve really internalized over the last few years is to think about the world in terms of networks, and our own value or role in those networks. The more interesting networks are not hub-spoke networks but rather mesh networks that can and do create value even while missing a node. Enabling that type of network is one of our goals with Foundry Group Next. A network becomes a community in the very best case. We try to foster that community and connections among our family of founders, partner funds, and limited partners.
One benefit of the last few challenging weeks has been bringing together our group of partner fund managers on a weekly basis. These get-togethers have a light agenda, but they really enable friends and peers to connect over the week’s challenges, share concerns, and have a little fun. It’s been especially gratifying to see the more experienced managers chime in actively, sharing prior experience and addressing some of the questions and concerns that the newer managers have been facing for the first time. It’s these consistent interactions and sharing that have enabled a feeling of community. We’ve also met with our direct portfolio of companies and those of our partner funds. It’s been heartening to see the consistency of leadership across our group.
We’ve been taking notes as we go along, and I thought that some of the more general thoughts would be worth sharing. Each of these points could probably be a separate post, but I thought it more important to get these out in the wild than to crisply edit. So, with apologies for the draft nature, I hope you enjoy seeing notes from a few of the shared conversations we’re having across our network.
What does the market environment look like?
- LPs, GPs, and Founders are all experiencing anxiety at both a personal and professional level. Today, most have made it through the initial shock of high anxiety, deep engagement, and triage mode with their portfolio or business. Consumer-focused businesses have almost certainly felt the first wave of change whereas many B2B companies have yet to see the real impact of a slowing economy. Look for that over the next two quarters as we experience higher churn and reduced sales for existing customers.
- Expect a lag in private markets relative to public markets, maybe 6-9 months if this is a real reset of pricing. Reset could become protracted, and that would be the best time to invest. A guess among the group is that we see valuations come down 20-30% and that round sizes will reflect that for dilution. We’re already seeing anecdotal data (or “anecdata” as we fondly call it) of this in the market.
- Valuations are already coming down in some segments, e.g., an experienced/pedigreed founder expecting 15M pre going into demo day, now expecting 9-10M pre and getting comfortable with investors pricing and not being able to “set” a price. The hot rounds are still “competitive” but not being bid up so much on price. There also seems to be a more pronounced “feast or famine” modality at seed/A rounds.
- Technology and innovation aren’t correlated to the markets. New investments are still building products and will come to market after this cycle turn. Are you willing to keep investing with a 2-3 year timeframe in mind?
- Deal re-trading: folks are starting to see it both for M&A and follow-on financings. Deals are being put on pause and/or terms are being retraded. We’ve already seen some bad behavior. Make sure you know where your syndicate partners sit w/r/t an inside round if the external deal falls away. Also, a reminder that pay-to-play rounds are usually a bad place to put capital. Think about what you’re defending. How much does this company matter to your fund? How hard will you be hit if you don’t play? Our experience is that it generally doesn’t work and creates an adversarial relationship between the company and investors. You definitely need to understand the founder’s position and the investor preference stack well.
Conversations we’re having with/about LPs
- This crisis will likely cause a ripple effect through the whole ecosystem. Everyone should over-communicate about working arrangements (business continuity plan in place), acknowledge some fallout in the portfolio due to business risk and increased financing risk, and provide guidance on capital calls/pacing over the next 3-6 months.
- Many LPs are essentially out of business until the end of the year – by their nature, LPs are conservative and will have a bias towards waiting, the value of the free option just went up as FOMO disappears.
- Some LPs might experience liquidity issues (e.g. hospitals and universities may need to spend more money on operations) and will be less liberal with their investments, particularly in new funds. Cash needs and spending are up at the same time that balance sheets are down. Liquidity fears are greater as LPs stare more directly at unfunded commitments.
- Staff and teams are likely feeling pressure from board/CIOs, and there’s no benefit to them for taking risk. They will focus on existing, proven relationships that are easier to get done. And our favorite CIOs will question (even more!) venture returns (and also anything with leverage). This will pose difficulties for younger funds especially ones that have more “adventurous” investment theses.
- Understanding where you stand in your LPs’ portfolios is imperative, having multiple points of contact is important, and you should not just assume a re-up from them if you have to raise this year. Do your best to slow down and not hit the market until 2021. There will be a logjam of funds trying to wrap up in the fall, and LPs are way overcommitted. If you are stuck fundraising, give LPs a little break to find their footing and tell them you’ll circle back in the summer to see if you can push to a fall closing.
- Capital calls should be maintained at a normal or slower pace if possible. LPs are unlikely to default; previous cycles were < 2%, almost solely individuals. LPs have little to lose if you haven’t called much capital. If less than 10% is called, you should keep a careful eye on it, as the cost of default isn’t so large. If you do have a challenged LP, we encourage GPs to proactively manage a secondary sale.
- Be prepared for LP questions.
- A portfolio analysis in light of COVID-19 is a good idea if you haven’t done it already. Make sure to point out which companies are most at risk, which ones benefit from this environment, and which ones can weather the storm and still be potential fund drivers.
- Capital calls for institutions should be fine, but it’s helpful to give them a heads up to set expectations for upcoming call schedules.
- For individual HNW LPs, you may need to be flexible and give a little extra time. It’s a good idea to give them a heads up on your expected call schedule as well.
- One detail that was interesting. You might consider doing calls as close to the beginning of the quarter as possible. (If you have a call outstanding and not paid at quarter-end, you’ll have to reflect that in financials.)
Conversations we’re having with/about GPs
- It’s important to acknowledge that we’re all humans.
- Likely to be fraught with emotion, people are tired, partnerships are stressed, maybe families are stressed. Really important to understand the full person across from you and their state of mind. And how their state of mind might affect their risk profile.
- Human nature is to draw in risk appetite in those moments when you don’t see continued income. You stop spending, raise the bar for anything new and are not confident to add more mouths to feed in a constrained portfolio size/fund.
- It’s been a helluva few weeks. We are all rightly focused on our existing portfolio. We need to focus there until we “find the bottom” and feel comfortable that companies are responding, or at least scenario planning, appropriately. Most people are expecting to get through that by May 2020.
- Portfolios need to be examined in the context of individual funds. Important to understand which positions retain option value and where you must concentrate capital. Now is the time to make hard decisions about which companies you can support. Distilling your investments can be a good thing for the performance of the fund, though it forces tough conversations and expectation setting with your founders.
- The balance between supporting the portfolio (triage/firefighting mode) and looking at new deals is challenging. It’s more of a challenge for firms with large existing portfolios, especially with more mature companies.
- Great opportunities will present themselves in this type of market, and at better prices. Many firms will remain active and even ramp up in this market. We should still be “crazy selective” on quality, and this group should keep working together.
- Painkillers > Vitamins. We should be investing in products that are critical to success. The nice-to-have products are the first to go in a downturn. Make sure you’re investing in solutions that customers can’t live without.
- Valuations are a real challenge in this environment. The general consensus is that we should all stick to our existing policies and see where the next quarter takes us. Q1 financials may take longer to finalize as we get a better sense for the macro environment, and we should all expect auditors to put footnotes in Q419 audit docs.
Conversations we’re having with companies
- It is important to act swiftly (while you still have the opportunity to make decisions) versus waiting and hoping that conditions will change and create more flexibility.
- Founders must be willing to confront a situation before they are forced to confront it (i.e., not all companies will be immediately impacted by the downturn but may face consequences in 1-2 years if they don’t make the necessary decisions today)
- There is more risk to underreacting than overreacting. In fact, overreacting might be a forcing function for reconsidering and optimizing business model, team operations, etc.
- In a time of displacement and crisis, you must have a bias towards action and a lens for confronting reality, no matter how difficult it is.
- Understand your existing investors.
- How strong are your individual leads at each fund?
- How does the rest of the fund portfolio look? Where do you fit in that portfolio? Do they have reserves for you? Have they done bridge rounds (convertible notes) for other companies?
- You need to understand the size and total portfolio of the fund that you’re a part of.
- Talent has been the biggest challenge for companies.
- Talent becomes more dispersed in up markets and more concentrated in down markets. You’ll be able to attract talent if you have a strong product/company/cap table.
- Like it or not, there is about to be a huge reshuffling of talent. The good companies will attract stronger talent, perhaps much stronger than that of the employees they are trying desperately to retain.
- How are you playing offense during this time? You can’t just hibernate during a crisis. Instead, you sharpen your focus. You divest in some/most areas, but you need to be investing in some area. The goal is to come out of this stronger than you entered in at least one critical area.
- Online CACs have come down in some categories.
- Do you have technical debt in the infrastructure?
- Do you have product work that can be prioritized?
- FOMO that exists at the top of cycles has disappeared As a result, startups will need to provide more data / demos / proof points to get VCs to bite. Think of venture funds as a table of diners that have just finished a big dinner, and you’re asking them to eat dessert. The best thing you can do is bring the tray around and SHOW them. Convince at least one diner to order the cake, and you may have others join. You’ll need to show more, demo often, provide more data, and recognize that your company has to be more compelling in this environment.
This post was way too long but I hope it gives you a sense of some of the conversations and learnings inside our community. We hope that sharing them out helps others and we’re always glad for more input, thoughts, and debate.