Startups and Macro Risk

I find it difficult to think of another time with as much macro risk as the present at least since the financial crisis and likely much longer than that. There is a shooting war in Europe with no clear endgame. China might make a move on Taiwan at any moment. We have an ongoing pandemic that could still produce a dangerous variant. US democratic institutions appear incapable of mounting a coherent response to pretty much anything and are under attack from within.

The broader stock market has held up surprisingly well in light of this. Yet many public tech stocks have already pulled back substantially. Bluechip names like Cloudflare and Shopify are down 50% off their all time highs. This is a reflection both of anticipated higher interest rates and lower growth. Still I would not be surprised if we wound up with a much bigger and broader correction, if any of these macro risks are realized.

Is this something a startup founder/CEO should be paying attention to? In order to answer this question it is useful to look at the interaction between private and public markets.

Private market valuations tend to lag public market valuations. This is fantastic for venture investors when you invest in a sector where public market valuations are just starting to expand because you can still get into deals at reasonable prices. This is when the best venture returns are achieved. That’s why being early (but not too early) to a new sector is so powerful and has been the underlying rationale for our thesis-based approach at USV. Once there have been great public market returns for quite a while private valuations go up accordingly and venture returns normalize.

Of course now we have entered the opposite part of the cycle. Public market valuations are down by lot in tech but private valuations are lagging behind and high priced private rounds are still getting done. This period will likely see some of the worst returns.

Now if you are the founder/CEO of a venture-backed company you might say that compression of venture returns isn’t your problem and you would be right as long as you don’t need to raise more money.

The biggest risk exists for companies that have raised at high valuations but can’t get to cash flow positive on the money in the bank and thus will need to raise again in the future. Once private market valuations catch up (and they will do so first for later stage companies) they may fall into what I have previously called the “post money trap.” You may find yourself in a situation where you have made a fair bit of progress with your business but the contraction of valuations has more than offset this and you would need to raise a down round which are notoriously hard to pull off.

If one of the severe macro risks is realized and the public market really tanks there is another problem that will significantly worsen the contraction. Pension funds and endowments the largest sources of money for venture firms will suddenly find themselves with too high an allocation to venture on a percentage basis as their public portfolios melt. That would happen at a time when most are already struggling with keeping up with the ever faster deployment cycles of venture funds and so feel stretched as is.

In the worst scenario only the very best performing funds will be able to raise again and even they may need to shrink their size. Put differently just as there are positive feedback effects that have accelerated the rise over the last couple of decades, there will be similar feedback effects that will accelerate a fall.

To be clear: there is no certainty about this. Public markets could also go up, especially if people conclude that the Fed will abandon its efforts to shorten its balance sheet. This would appear to have been true during the first couple of days of Russia’s invasion of Ukraine. But just because the market is up a bit doesn’t mean that the macro risk has gone away.

So how should you approach this as a startup founder/CEO? If you have raised a round at a really extended valuation in the last 6-12 months I would strongly advise making this cash last a lot longer than you had originally planned. Ideally see if you can get to cash flow positive or within striking distance of that on the money you have. And if you have the opportunity to take some more money right now by all means do so.

You can always choose to reaccelerate spending at any time. But you can’t count on being able to raise when everyone else is running out of money also. Now, more than ever, is the time to make your business antifragile.