What VCs should be doing in a down market

This is a two-parter, since its always instructive to compare the ideal with the actual ...

Every company I’ve ever started was done in a recession--you know all the reasons: people are available, your competitors are pulling back giving you a great chance to be ahead of them when the market turns positive again, etc. etc. It's very hard to go to market when there isn’t one--and in this environment customers are scared of the future and are delaying buying decisions. Time to market has become irrelevant--so called first mover advantage (please don’t ever use this in a pitch) never was relevant. So if your company is early, and developing something really revolutionary that may take one or two years to create then ideally VCs should be really interested in this, provided the burn rate is manageable and it doesn’t require a massive infrastructure investment.

When the market inhales,large companies cut R&D projects and really high quality people get bored and become available to start or join new tech startups. VCs need to find these teams and embrace them because they create the next round of Googles and Ciscos. Be under no illusion it's harder today to get funded than ever before, because these great teams are out there and if you are competing with deep domain experts you will likely come up short. Also, VCs are human too (well, almost) and are just as scared and uncertain as everyone else, so making the funding decision will take longer and longer, and each time the market takes another big hit they will be reminded just how tightly closed the IPO exit window is, and that they have to have another round of explanations with their LPs as to why the money should stay in the fund. At the same time, their LPs are hammering on their management fee, and wanting to know why they are paying it if the partners are not investing.

I think there are two basic choices in this market, other than the non-choice of do nothing and sit on the money until things get better. VCs first triage their portfolios to see which investments can and should survive, circle the wagons around the portfolio and make sure they have a low enough burn and enough runway to make it. Then they can either go out in a predatory way and force their way into deals they would otherwise be unable to enter, leveraging the fear factor. There is a natural bias towards later stage deals--i.e., doing series B & C deals at A-round pricing--remember many of these firms need to have an exit soon, and given that public markets are closed the only option for many is to be able to sell a later-stage company to demonstrate a return to LPs who have seen nothing but losses for the past year. The problem with this path is it does not leverage the natural skills of a VC--there is a lot less value to add to a later stage company and it looks more like a banking deal. Also there are a lot of bankers and other VCs also looking for that type of deal ;-)

The other path is to forget revenue and look for highly disruptive plays that may take two years to develop their product but when they do it can really cause order of magnitude changes in the business model. These are extremely risky, and often more like science projects than businesses but they also offer venture scale returns--10 to 100x and it only takes one good one to make an entire fund (one of the Google VCs experienced exactly this win in a portfolio that was otherwise abysmal--and who says we are so smart...)

It’s a shame to waste a good crisis, in good times companies are struggling to meet orders and focus all their efforts on supporting manufacturing and keeping the engine running. They have no time for revolution. In times like this they need aspirin for the pain, not steroids for performance--it is a time for revolution. And a little revolution now and then is usually a good thing ;-)

Next time: What VCs are actually doing in this market (this one might take a while...)