Temperature Check

It’d be foolish to say anything publicly right now and not acknowledge what’s on everyone’s minds — the coronavirus pandemic (along with the impending market downturn) is great cause for concern, capturing our nation and the world economy. Truth be told, business as usual is hard while this disease sweeps across our communities, coming into contact with potentially millions of people which will include loved ones and close friends. But, we must keep pushing on. Looking out to the next few months, it’s going to be a rocky road for businesses and capital allocators, but there are smart people who have seen multiple cycles with pragmatic advice on powering through — keep cash tight, focus on product + R&D, expect slower sales cycles. And with respect to the virus, follow and pay attention to experts (virologists, epidemiologists, public health officials), not VCs.

At times like these, when every day seems to feel like a year, I find it personally valuable to write down what’s in my head and take stock of the situation. I don’t have a crystal ball, and it’s impossible to know where the world is headed, so I’m orienting towards observations over predictions. Odds are, these notes will help with personal accountability in a few months, but hopefully others can find some use in them.

I came of age during a bull run, and now the veil of unbridled optimism has been lifted away.

In capital efficiency we trust: Given the newfound prevalence of remote work and distributed business, investors are taking a deeper look at self-serve, low-touch business models that can survive these upcoming months. It would be a mistake to over-index an investment strategy on the current moment (the best frameworks take the long view!), but the renewed focus on capital efficient businesses is a conversation always worth having, separate from daily market movements. Capital efficiency powers businesses through bear markets and propels them forward at a greater velocity during bull runs.

I’ll borrow from Michael Mauboussin to define capital efficiency. According to him, “a core test of success for a business is whether one dollar invested in the company generates value of more than one dollar in the marketplace.” Most startups venture capitalists invest in tend to be more efficient on the whole than sectors of the old-world economy (manufacturing, energy, infrastructure) given the scalability of software and networks. However, even within the venture capital universe, some models prove out to be more efficient than others. They tend to have organic growth fueled by product and self-serve distribution, low operating costs, and a deep sense of the customer pain point. Investors in the public and private markets will pay more attention to mission-critical software infrastructure (primarily OSS), APIs, bottoms-up SaaS, etc.

Only the strong survive? Companies have soared to multi-billion dollar valuations or outcomes in categories like travel, local commerce, and other forms of discretionary consumer. Some of them are great businesses with solid fundamentals. In any other parallel universe, they would have continued to carry on and scale. Yet, these macro conditions — the pernicious effects of the virus, social distancing, and a looming recession — pull the rug out from under technology companies in affected categories, to no fault of their own. Some may falter in the public markets as mutual funds and retail investors sell off. Others may try to find ways to cut burn in the late-stage private markets as financing could dry up. But, I doubt there will be a unicorn bailout.

This is the downside of the “software eats the world” paradigm. The emergence of software and data within an industry do not shelter it from cyclical and macro situations. This is also the reasons companies stock pile cash (for example: Airbnb and their war chest should be fine). Investor Nick Sleep refers to this as “slack in the system.” When you wind the system up too tight and spend, spend spend, there is no leeway for decisions down the road. One assumes that the total universe of options is available at the moment, and the safety net for tough times collapses.

Fintech Jekyll and Hyde: Before the virus hit, fintech was on a roll with the Plaid and Credit Karma acquisitions. As the Fed looks to stimulate the economy, I’m curious to see how the interest rate fiddling will impact the underlying economics of fintech startups and challenger banks. Some of them already had shaky fundamentals and value propositions, which could fall by the wayside in an economic downturn.

The counterargument is that consumer trust in legacy financial institutions will erode at a higher clip now. Financial services that align themselves with end users, don’t nickel and dime, and provide a modern experience will come out stronger. Infrastructure tools (like Plaid) will continue to make their bread amidst surges in transaction volumes and volatility. This all goes to say that the shock in the system is like a Rorschach test for two faces of fintech.

Whose market is it? Over the past few years, there’s been a saying that “it’s an entrepreneur’s market.” With a glut of capital in the early-stage venture market, founders controlled their destiny when it came to financing — timelines, round construction, etc. Founders with momentum (in the form of either narratives or real traction) dictated how their rounds came together.

But, when the tide pulls out, party rounds can burn founders. The dynamic may shift back into investors’ hands as the pursestrings get tighter. My hope is that VCs don’t relish too much in this or view it as some sort of victory when valuations come back down to earth. An entrepreneur’s market is a net positive. Those who build the future should inform the structure of how to get there.