The Best Time To Invest In Startups? Always.
Keeping a balanced investment portfolio has long been standard practice within the financial industry, with good reason. Rebalancing forces investors to sell assets that have outperformed, and to buy more of the holdings that have underperformed. This can test emotional biases, as most people don't like buying dogs and selling winners. But decades of data validate the strategy. Venture investing requires the same kind of fortitude and discipline that underpins rebalancing.
The market for investing in startups behaves differently than those for equities or bonds, but just as with traditional markets, the venture ecosystem experiences peaks and valleys. People tend to pile into angel and venture investing when the market is rife with IPOs, acquisitions and gaudy valuations. But by only investing during peak times, investors miss not only the opportunity to buy into startups at lower valuations, but they also may miss the chance to invest early in the next Airbnb, Facebook, Dropbox or Uber—all of which raised seed and A rounds during languid periods for venture capital investing.
Keep a steady hand, don’t worry about short-term forecasts
While this position may seem rudimentary, it's flouted by many venture investors who charge in with fists full of cash during times of economic growth but meekly disappear during slowdowns. Although some are debating whether venture capital is now in a pullback mode, the 30% decrease in venture funding during the fourth quarter of 2015 suggest this to be true.
Most VCs seem to understand the theory of buying while prices are low. WSJ reported that VC firms added to their coffers at the highest rate in more than 15 years during the first quarter of 2016. Yet they've been reluctant to pull the trigger and write checks in an uncertain environment, evinced by the languid deployment of capital in the last quarter of 2015 and first quarter of 2016.
This, then, may well be a time of opportunity for startup investors who can ignore the herd.
Investing steadily over time is important in any kind of asset market, but it’s imperative within the venture arena. A bull market in equities could bring a 50% upswing—market timers who miss half of that surge could put their portfolios behind benchmarks like the S&P 500 forever. But for startup investors, totally pulling out of the market could be more disastrous. Even the best VC funds get built around three to five big wins, or, in some cases, when the win is Facebook or Google, just one. Timing the market on Wall Street has proved to be nearly impossible. Timing the market for startups is harder given that venture investing results in highly nonlinear returns, even more so than traditional financial markets.
“VCs bet on emergent trends with a 7-10 year investment horizon,” points out Mo Koyfman, general partner at Spark Capital, an early backer of Twitter and Oculus. “Trying to time markets in this context is a fool's errand.”
Even some of the most experienced investors and LPs will make mistakes in this realm. Harvard’s endowment fund, the largest of its kind, quit as an LP at Accel Partners in 2004 after the VC firm didn’t invest in Google and its portfolio floundered in the post-boom market. A year later, Accel invested $12.7 million in erstwhile Harvard student Mark Zuckerberg. The university endowment missed the opportunity to bet on one of its own and capture what would have been at least a 700x return. The endowments of Princeton and MIT, prolific by all measurements, also quit Accel before the Facebook investment.
“Sitting out during times of short-term tumult is akin to not planting a fruit tree because it’s windy outside,” says Chris Douvos, managing director at Venture Investment Associates (VIA), a LP in leading VC funds including First Round Capital.
Gems often emerge during down periods
There have been three demonstrative peaks in the startup market during the last 25 years: 1999-2000, early 2008, and most recently 2014-Q32015. The backside of these bull markets, where some angel investors, VCs and LPs held back, are where some of the most interesting companies in the world found their early backing.
The malaise following the first tech boom continued all the way into 2005. During that time, in addition to Facebook, Kayak landed its $10 million Series A in March 2004, Tesla got its $7.5 million Series A just a month later, and before that, Skype landed a small Series A from Bessemer in January 2003. These companies came to define their spaces and net major gains for those early investors.
Many investors again grew timid following the 2008 economic crash, but this was arguably one of the better periods the venture market has seen. Consider:
Dropbox - $6 million Series A, October 2008.
Twilio - $600,000 seed, March 2009.
Airbnb - $600,000 seed, April 2009.
Uber - $250,000 seed, August 2009.
Square - $10 million Series A, November 2009.
Even Paul Graham, co-founder of startup accelerator Y Combinator, expressed concern on where things were headed. “The winter of 2009 was the YC batch where PG cautioned there might not be any investors writing checks at Demo Day,” remembers Garry Tan, a former Y Combinator partner and current angel investor. “Fitting that the biggest success at YC so far happened in the middle of RIP Good Times.”
Tan was referring to Airbnb, which got $600,000 in seed capital from Sequoia in April 2009. Tan also referenced a presentation Sequoia put on for its portfolio companies in the fall of 2008 shortly after the fall of Lehman Brothers and the beginnings of the Wall Street bailout. Sequoia’s slide deck for the event chronicled the economic reasons for what it saw as an extended dark period coming for startup funding. A picture of a gravestone with the words “R.I.P. Good Times” headlined the deck, and it has since become part of Silicon Valley lore. The next few years saw a slowdown in venture investing, but things never grew as dire as Sequoia’s forecast.
Sequoia preached doom, but it also seized the opportunity to invest in great companies when others were on the run. Just a week after its RIP Good Times presentation in October 2008, Sequoia closed on the series A for Dropbox. Sequoia did decrease the amount of money it sunk into seed and A rounds in 2009 compared with 2008—$136 million to $48 million—but it only cut one less check: 13 in 2009 compared with 14 in 2008, according to data from CB Insights. A disciplined and seasoned investor, Sequoia kept its place at the table and maintained its investing pace in 2009, post-crash.
Some Elite venture investors increase their investment rate during pullbacks
Some shrewd investors even increased the clip at which they deployed money into early-stage companies through this time. First Round Capital, which participated in Square’s $10 million Series A in November 2009 and led a seed round for Uber in October 2010, ramped up early-stage activity during the crash from 17 investments and $23 million in 2008 to 23 investments and $65 million in 2009. Venrock behaved similarly, going from $83 million invested in 12 early-stage investments in 2008 to $116 million in 14 early-stage investments in 2009.
Other aggressive investors in seed and A rounds from the time included True Ventures, which increased its spending 50% in 2009. It participated in Fitbit’s Series A in late 2008, and Puppet Labs’ and PayNearMe’s Series As in 2009. Founders Fund cut 7 early-stage checks in 2008, and then more than tripled that number in 2009, getting into 24 seed and A rounds. Among them: Twilio, Yammer and bit.ly.
“We believe great companies emerge during both boom times and bust times—and that sticking to our investment model (and strategy) is especially important during both ends of the cycle,” wrote First Round partner Josh Kopelman in a recent letter to his LPs.
There are few macro signals of use to venture and angel investors, and the market isn’t nearly as elastic as that for equities or debt. But a marked slowdown in the venture market is one of the few buy indicators available to those interested in startup investing. The best venture funds know this, as evinced by their investment patterns. It’s the kind of common sense that retail investors in conventional markets never seem to embrace.
Companies that flourish during these down periods learn to operate leanly with an eye toward efficiency and cash preservation. Brian Matthews, cofounder and general partner at Cultivation Capital in St. Louis, says his firm “continues to invest at its normal pace, but we recently told our portfolio companies to watch their cash burn a little closer.”
Companies with slow burns have time for well-conceived product evolution and, in some cases, lucrative pivots. The venture market was still relatively quiet when Accel and Andreessen Horowitz invested in Slack’s seed and A rounds in February and April of 2010. At that time, Slack was a gaming company. It’s since, of course, become a maker of productivity software for teams valued at more than $1 billion.
Venture investing will always be about homeruns, which, like Slack, are never easy to identify. But spotting outliers and the teams behind them can get easier in down markets because middling companies and wantrepreneurs exit the scene. The same can be said of startup investors: the dumb money leaves, the smart money digs in.
“I remember in 2007 many investors stopped looking at seed stage companies and we seeded Dropbox, Lending Club and Zoosk in that year,” says Pejman Nozad, one of the more prolific angel investors in Silicon Valley, now managing partner at PejmanMar Ventures. “There are always true entrepreneurs out there solving real problems, no matter the condition of the market.” Many major LPs agree with Nozad.
After surveying 73 LPs earlier this year, Upfront Ventures found that 82% of them want to maintain their current investment clip in the face of the venture downturn. Just as compelling, 8% of the LPs wanted to increase their investment pace in venture capital. That leaves only 10% of the LPs who wanted to pull back. These are the venture investors who would have missed on Facebook in 2004.
Investors who pull back risk missing out on generation-defining technology platforms
Pulling out of the venture market for any reason can deny an investor the benefit of two other modulating effects: the rise and adoption of a new technology platform; and true diversification, something that is uniquely time-dependent within the venture sector.
As for the latter item, most investors know how to diversify across conventional assets. It can be as simple as buying ETFs focused on domestic and foreign equities, bonds, real estate, commodities, etc. Diversifying a venture portfolio isn’t so simple. Startup trends tend to come in waves that can last quarters or years. For much of 2010 and into 2011, for instance, Groupon copycats and flash sales sites composed a good portion of the deal flow. And while mobile gaming startups may be popular for a stretch, virtual reality companies may usurp them a few quarters later. Only by staying active during all of these runs can investors get exposure to the best companies in a given space.
Perhaps more important, it’s always been difficult to predict when a new technology platform will turn from curiosity to staple. Venezuelan economist Carlota Perez has parsed this subject by researching all of the major technology paradigm shifts going back to the beginning of the industrial age in 1771.
She demarcates the fitful early days of a technology, when it’s solely the province of dreamers and early movers, from the period of mass adoption with an S curve. The bottom of the S is rather flat, with a tepid upward curve—she calls this the installation phase—and the middle of the S, the turning point, comes suddenly, leading to rapid growth during the deployment phase. We’re currently negotiating the lower portion of the S on several technologies: artificial intelligence, VR/AR, self-driving cars, cryptocurrencies, and robotics technologies. It is likely that another several technologies not on the tip of the tongues of most VCs are also negotiating this curve.
But predicting exactly when these platforms will break loose is a parlor game. Luck plays its role, but venture investing shouldn’t be a pure game of chance. It should be an endeavor in which discipline wins out and regular investment nets viable plays across different sectors and, to steal a term from the wine world, different vintages. That construct of deploying capital across time and landing exposure to companies reared during different periods is something that’s built into venture capital. VC firms dispense their funds during three-year periods, and run series of funds in a row to passively ensure of this effect of time exposure. Good LPs want not only sector diversification, but they also want vintage diversification. This is how, despite striking out on three AR companies, a fund hits on the one, two years later, that becomes the vanguard within the space.
“I like to anticipate what might happen in the future, but I don’t need to be certain of the outcome to invest,” says Tim Draper, founding partner at Draper Associates and DFJ. Draper backed Cruise Automation, recently acquired by General Motors for a reported $1 billion.
Most investors like to think they heed Warren Buffett’s oft-repeated maxim, “Be fearful when others are greedy and greedy when others are fearful,” but the data tell us that most don’t. When the global economy and the stock market tank, there’s often what’s called a flight to quality, as investors pour into blue-chip securities: U.S. Treasuries, gold, and old-school defensive stocks like Procter & Gamble and Coca-Cola.
The same thing can happen in the venture investing world. If more clever startup investors want to remain active in these leaner markets, then opportunities to buy into the best companies with the best teams may not get patently cheaper. Investors have actually seen a bit of this recently as Y Combinator’s Winter 2016 class put on its final demo day pitches. Khosla Ventures’ Keith Rabois, not one to blindly toss compliments, called it YC’s best batch ever. FundersClub’s Investment Committee continues to encounter startups that are overpriced for the present market, something that can hamper a company’s future fundraising. That said, a high valuation alone is not a rationale for an automatic pass on an investment.
If investors glean nothing else from all this, they should at least know that the kinds of trends that drive newcomers to look at startup investing—ballooning late-stage valuations, clusters of acquisitions, a blistering IPO or two—should have zero bearing on how current opportunities should be measured. Early stage startups require at least five to seven years before the exit climate has any effect on them, by which time an entire economic cycle may have passed. With the future so uncharted, there can be only one good strategy. Luckily, it’s a simple one: identify the best startups, invest, and repeat.