The thing about cycles

The Internet is awash with gloom-and-doom predictions about the death of many unicorns, a down market for investing in startups, falling public company multiples and a massive disconnect between private and public valuations.

Bill Gurley has been warning about investors “discounting risk” for almost two years. Mark Suster of Upfront recently conducted an interesting survey of investors exposing their expectations for a slowdown in the funding market. He also wrote an incredible post on why valuations are falling and VCs don’t like it.

Jeremy Philips of Spark penned an op-ed in The New York Times about competitive advantage, highlighting that there are very few companies that have true network effects and that most companies win due to scale. Eight months ago we penned a blog post about how the “Pursuit of Unicorns Is Ripping the Soul Out Of Entrepreneurship,” leading to an assault on the obsessive pursuit of Unicornism.

Just like Unicornism was a herd, and the up market in late-stage funding was a herd, as pessimism grabs hold, it too will become a herd. Famed investor Howard Marks wrote in his recent memos, “I think it’s emotion that is synergistic. It builds on herd behavior and mass hysteria.” Nowhere is this more true than the high-risk venture business. However, the venture business is about identifying the outliers.

The great entrepreneurs and operators love the down market.

Therefore, it is important to keep this in mind: Innovation is not cyclical. While financial markets, economies and investor psychology are cyclical, innovation is not. Some of the best companies are born during the downturns. Uber was founded in 2009, Airbnb in 2008, WeWork in 2010. If you harken back to earlier cycles, you will find others. Why?

In a downturn, “tourists” (sometimes called “wantrapreneurs”) leave the market. There are lots of tourists in the business of entrepreneurship. As Suster mentions, there are some not-so-hearty entrepreneurs who will take the Google or McKinsey job in the down market, when money is tight.

As I wrote six years ago in the Hummus Manifesto – Part 1, many 2-4 person startups that are not sustainable will close, and their incredible engineering, product and entrepreneurial talents will be recycled into more disruptive, innovative and scalable companies. Which brings us to the question of how unsustainable small companies survive as long as they do.

Investor tourists also leave… Suster highlights that valuations were inflated by the large public market funds participating in the “venture market,” tripling the amount of capital in the market.  There is another set of tourists that inflated the entrepreneurship market when the stock market is rocking: newbie-angels and crowdfunders (remember MeVC?). I don’t refer here to professional angels and entrepreneurs who recycle their gains to the next generation of entrepreneurs — they are the lifeblood of the seed-stage entrepreneurial systems; those are the angels that funded Google, Facebook, Airbnb, etc.

I have been a VC investor now for at least three cycles. I don’t feel that old, but I guess I am. When the stock market rises, more people grow wings and become angels. It is what the “cool” people talk about at cocktail parties and conferences. In up markets, when everyone is making money in the public market, these angels differentiate themselves by talking up the cool startup they discovered and “got some angel money into.”  In every up market, doctors, dentists, lawyers, real estate owners and others take their winnings from the stock market and invest in seed-stage startups.

It is unsettling to realize that not every startup is a moonshot.

They either join clubs, follow their friends or, in the last two cycles, join crowdfunding platforms. As Gurley wrote, there is a bit of Madoff-ism in these clubs and, I would add, people get in without fully internalizing how risky this business is. Therefore, when the market goes down, fear takes over and they run the other way. Emotional investing is contagious, angels are “over-indexed” and many startups go to ZERO. That is frightening.

Worse, as prices come down, write-offs become more numerous and the angels become more skittish. Then, their portfolio companies need to raise money from institutions at tougher terms, and those early angels are often unprotected. As Suster wrote in his latest post on burn rates, those companies are also the most vulnerable to too high a burn rate, and they don’t have an investor who is deeply involved in helping the portfolio company sort out its problems.

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The fundamental challenge is that VC and startups is not a portfolio business. It is an outlier/aberration business. A tiny number of companies generate the bulk of returns; most investments lose money. As we have written before, the VC index loses money. Often, these ultimately home-run companies go through stomach-churning brushes with death that only the heartiest entrepreneurs and tough-minded, dedicated investors survive.

Most often, when the tide goes out, many of these new angels are correctly disturbed and despondent, left with too little reserve capital for all of those “bets,” and they are crushed in resets or internal funding rounds. Their fledgling investments close, or they realize that they will require a lot more capital for the long haul.

It is unsettling to realize that not every startup is a moonshot, that entrepreneurship is not as glamorous as it might look on TV and that the Angel of Death visits these companies more often than not. I always feel for these angels as the cycle turns. It is hard to watch, because their angelic hearts are in the right place.

The good news for the ecosystem is that there will be fewer middling companies that are surviving on the backs of these tourist investors. That will free up talent to enable more innovative and scalable companies to grow.

The great entrepreneurs and operators love the down market, so this is THE best time to invest if you can stomach it. Moreover, our local pond is well-suited for investing in the downward part of the cycle. In my three-four cycle experience, Israelis, blessed with an abundance of optimism, resilience and scrappiness, are particularly good at starting companies when others are fearful. Although Wix* was founded in 2006, it really got itself going in the crash of 2008. Mobileye was founded on the eve of the 2000 market meltdown.

For the last three years (since we started Aleph), rents have been high in San Francisco, Tel Aviv and NYC. The cost of talent has been high. Spendthrift competitors have increased the cost of doing business and economic sloppiness (bad unit economics and insane marketing spends) has become the norm. These heady times can make it tough for entrepreneurs to break through the noise.

This new market environment will favor crisp operators and deep strategic thinkers who build real moats around their businesses, develop deep technology and tightly manage their unit economics. Constraints actually increase innovation; we could not be more excited to partner with the next giant companies to emerge from a downturn. As Marks says, and the chart below shows, great investors “are looking for instances when the market is wrong” or the entire herd is stampeding.

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*Full disclosure: I was on the board of Wix.