Most venture capitalists aren't worried about the next economic downturn. To be fair, it is notoriously difficult to predict a recession or its severity.
Nevertheless, many investors and other observers are growing wary that an end to one of the longest economic expansions could be in the offing. Some cite the effects of US-China trade tensions. Others point to the warning signs of an inverted yield curve and lower investment returns. Above all, many increasingly talk about the coronavirus outbreak and its power to spur a global recession, such as on Thursday when investors at Sequoia warned of the epidemic showing "black swan" potential to upset the world economy.
Whatever your economic indicator of choice, it's always wise to stormproof a company for the rainy day that will eventually arrive.
To prepare for the next downturn, many venture capitalists are sketching out strategies for sustainable growth and guarding against threats to come. Following recent struggles faced by newly public companies, some investors already have been pressing founders to be more mindful of the fundamentals of running a sound business: cut unnecessary expenses to extend cash runway, expand their customer base, be sure to have a dependable board of directors and, at last, become a great storyteller about how their company is successfully solving a problem.
It's just a matter of emphasis now.
"My job is not to make a guess about when the next recession could be triggered," said Aydin Senkut, who founded Felicis Ventures in 2006. "It's just to be better prepared, that's all."
As surprising as it was alarming, a handful of high-profile companies including WeWork dominated headlines in 2019 for ignoring profitability in favor of aggressive growth strategies.
"Companies can always spend unlimited dollars to get revenue growth, but they don't necessarily make a great investment if their margins are going to suck," Senkut said.
There are ways to optimize primary financial performance indicators such as revenue and gross profit. That's why Felicis Ventures increasingly emphasizes measures where it's often harder to move the needle, like revenue per head or revenue per dollar spent. Senkut said that these tend to be a more reliable gauge of what's really going on at a company.
Some corners of the economy tend to be more resilient than others when a recession hits. "However, just because you're in the hot segment doesn't mean your fundraising is guaranteed," Senkut said.
Eric Hippeau, a managing partner at New York-based VC firm Lerer Hippeau, knows a thing or two about fundraising in the aftermath of a recession. Historically, startups might find it difficult to raise capital if recession warning signs are flashing red. But according to Hippeau, capital will continue to be deployed the same way it was after the Great Recession—cautiously. An economic downturn may constrain the ability of limited partners to make new fund commitments and as a result, VCs are likely to tighten investment criteria.
The good news is that global VC investors are sitting on nearly $189 billion of dry powder as of the end of June 2019, according to PitchBook data. Investors usually don't have the luxury to sit on capital as that could impact the timeline and returns of their ongoing funds. The enormous amount of dry powder suggests that despite a more cautious approach, investors are unlikely to significantly reduce capital deployment.
"No matter what the economic circumstances are, there's always capital for companies that have the proper market fit," Hippeau said.
It's all about cash management and the need for founders to come up with a solid contingency plan, which also underscores the importance of working with investors practicing a well-defined reserve policy.
Hippeau wants to make sure that his portfolio companies remain focused on satisfying their customers, as that can eventually help them ride out tough economic conditions.
"The VC game is a long game," Hippeau said. "It's a multiyear game, and a recession should not really have a major impact on the future of a fund or its portfolio companies."
That brings us to how investors and entrepreneurs can prepare a simple recipe to face long fundraising cycles amid a looming economic downturn.
Hippeau, who primarily invests in consumer, B2B and enterprise software companies including LeafLink and OrderGroove, said that during economic recessions and recovery periods, consumers' purchasing behavior changes. For that reason, it's important for companies to maintain a high net promoter score, a measure of customer experience.
"It's really a question of making sure that you have the right customer base because they are not going to abandon you," Hippeau said. "They might be a bit slower in renewing their subscription or buying additional products, but they will not abandon you."
Susan Choe, a longtime entrepreneur and founder of Katalyst Ventures, said one key to surviving a recession lies in focusing on revenue composition. It's a red flag, she said, if a company derives a significant chunk of their revenue from a single customer.
Choe, who has been on both sides of the investment table, also emphasizes a lesson learned from the financial crisis: Select board members who can be easily approached with news, both good and bad. From ex-bankers and fundraising experts to growth investors with high networking skills, everyone plays a different role on a board. It's like a professional family, and an understanding between diverse personalities around the room is vital to analyze what went wrong when problems arise.
On the other hand, TJ Nahigian, co-founder of Base10 Partners and a former investor at Accel, is maintaining a more watchful eye over economic indicators hinting toward an impending recession.
Nahigian said he's already seeing less overall access to capital in the last six to 12 months. Base10 Partners, an early-stage firm focused on task-automation startups, raised a $137 million debut fund in 2018.
He has urged his portfolio companies to prepare for diminished access to capital. One way to do that is to achieve break-even point or profitability sooner than they otherwise would.
"Portfolio companies are now expected to share higher revenues, higher margins, faster paybacks and more control over their own destiny than before," Nahigian said.
Ilya Fushman, a partner at Kleiner Perkins, which on Thursday announced it closed a $700 million new fund, said that companies should hold off on deploying capital until they understand business drivers that enable them to become category-owning companies offering a defensible product or service.
"It doesn't make sense to scale if you don't really know what you're scaling," Fushman said. "It's just good advice in a healthy market, and it's good advice during a downturn."