“Fortunes are built during the down market and collected in the up market."
- Jason Calicanis (Angel Investor, Syndicator, Author, Podcast Host)
For many, our contemporary economic times are unfamiliar territory. We’re facing:
In today’s environment rife with complexity, what is actually happening, and how can founders navigate this uncertainty?
In this piece, we’ll explore:
First, it’s important to understand what is happening. The crux of this analysis will deal specifically with technology and growth stocks and the impact of rising interest rates, which came as a result of high levels of inflation.
As it relates to financial markets, inflation (and the Federal Reserve’s corresponding actions in an attempt to tame it) is arguably the single biggest culprit behind the current volatility; as rates rise, this has tremendous ripple effects across the economy. As mentioned previously, inflation (for most of 2022), has been at 40-year highs, as evidenced in the chart below.
Looking at data month-over-month data from 2020 to 2022, the steadily increasing pace of inflation can be seen quite clearly.
The Federal Reserve (known as the "Fed"), being the central bank of the United States, is responsible for implementing monetary policy in the country. One of the critical tools that the Fed uses to influence the economy is the setting of interest rates. When there is high inflation present in the economy as there has been for the last year, the Fed normally raises interest rates in order to reduce the demand for goods and services (known as demand destruction) and slow down the rate of economic growth (when the economy shrinks for two consecutive quarters, it’s called a recession).
Why does the Fed do this? There are several reasons why the Fed might choose to raise interest rates in response to inflation:
Because of this, a rising interest rate environment makes safer, fixed income securities (such as bonds) more attractive.
Why is this? Bond prices and interest rates have an inverse relationship, which means that when one goes up, the other tends to go down. Interest rates determine the coupon rate on a bond. The coupon rate on a bond is the interest rate that the bond pays to its holders. When interest rates rise, the coupon rate on new bonds also tends to rise which means that the yield on those bonds will also be higher, making them attractive to investors. Conversely, when interest rates go down, the coupon rate on new bonds also tends to go down, which means that the yield on those bonds will also be lower.
How does this impact technology stocks?
The answer is quite simple. The volatility in technology stocks, in particular, can be observed within a fundamental and industry-standard financial valuation technique: the discounted cash flow model (known as the DCF model). A DCF can be used to estimate the present value of a series of future cash flows. It is based on the idea that the present value of an investment or asset being the sum of all of its future cash flows, discounted to the present at a specified rate. The technical formula is given below.
Why is this important? For one, although not perfect, the DCF is widely used across the industry (in both public and private markets). Most importantly however, seen in the model above, there exists a critical relationship between interest rates and the discount rate (a component of the denominator) of a standard DCF.
In discussing this, it’s important to remember that for years, technology company valuations were inflated due to a historically-low interest rate environment. In general, when interest rates rise, the cost of borrowing money increases, which can make it more expensive for companies to finance their operations and invest in new projects; the inverse is true when interest rates are low.
As a result, the perceived risk of investing in a particular asset may increase, which can lead investors to demand a higher required rate of return (the discount rate) to compensate them for taking on the added risk. In this way, the discount rate may rise as interest rates rise, as investors seek to compensate for the increased cost of borrowing and the increased risk of investing in a particular asset.
Thus, when interest rates rise, the discount rate will also tend to rise, which can reduce the present value of future cash flows and decrease the intrinsic value of a company as calculated using a DCF model.
The higher the discount rate, the lower the present value of the future cash flows, as a higher discount rate would mean a larger denominator, resulting in relatively smaller cash flow projection in any given period.
Per a DCF, this valuation analysis would hurt all stocks as interest rates rise, but in particular hurts growth stocks, where future earnings get discounted with higher interest rates. It's important to note, however, that the relationship between the discount rate and interest rates is not always straightforward and can be influenced by a variety of factors.
It’s important to keep in mind that a DCF isn’t the valuation technique impacted by rising interest rates. Price-to-earnings ratios (P/E ratios), a measure of the price of a stock relative to the company's earnings per share, are a quick and easy means of evaluating a company, especially within public markets.
What’s better: a low P/E ratio or a high P/E ratio? The answer is it ultimately depends on the specific circumstances of a company and the expectations of its investors.
A P/E ratio is calculated by dividing the current market price of a company's stock by its EPS, or earnings per share. Generally, investors may consider a low P/E ratio to be attractive because it suggests that the stock may be undervalued and has the potential to generate higher returns. However, a low P/E ratio could also be a sign that a company is experiencing challenges or has low earnings relative to its stock price. On the other hand, a high P/E ratio may indicate that a company is performing well and is expected to continue growing, but it could also indicate that the stock is overvalued and may not offer as much potential for returns. As you can see, there’s no clear-cut answer, and P/E ratios can be influenced by a variety of factors, including the expected growth of a company's earnings, market conditions, and investor sentiment, among other things.
Rising interest rates can impact price-to-earnings ratios in a number of ways.
After understanding the technical finance component of what’s causing downturns and disruptions, Y-Combinator, in a letter to portfolio companies, noted how the performance of public markets (specifically technology stocks) impacts venture markets.
Understand that the poor public market performance of tech companies significantly impacts VC investing. VCs will have a much harder time raising money and their LPs will expect more investment discipline. As a result, during economic downturns even the top tier VC funds with a lot of money slow down their deployment of capital (lesser funds often stop investing or die). This causes less competition between funds for deals which results in lower valuations, lower round sizes, and many fewer deals completed. In these situations, investors also reserve more capital to backstop their best performing companies, which further reduces the number of new financings. This slow down will have a disproportionate impact on international companies, asset heavy companies, low margin companies, hardtech, and other companies with high burn and long time to revenue.
It’s important to bear in mind that while the tangible and visible disruption is happening in public markets (as seen on CNBC at any given hour), public markets influence private markets in a variety of ways. The public market is a strong indicator to venture markets as it relates to comps, multiples, and exits. Disruptions in the public market have a direct path to disrupting the private markets.
Outside of a purely technical method of evaluating what’s happening in the markets, it certainly helps to give historical context.
Has this happened before? The answer is yes… to a degree. Many technology investors agree that the dot com bubble is likely the closest economic downturn resembling what’s currently happening.
The dot com bubble was a major economic downturn that affected primarily companies that were involved in the internet and e-commerce in the late 1990s and early 2000s. The dot com crash was caused by a combination of factors:
The dot com bubble began to inflate in the late 1990s, as the internet became more widespread and companies rushed to create websites and online ventures. Many of these companies went public, raising large amounts of money through initial public offerings (IPOs). As a result, the value of tech stocks soared, and the market was flooded with new companies looking to capitalize on the hype.
However, as the bubble continued to grow, it became clear that many of these companies were not profitable and were overvalued, as they struggled to generate sufficient revenue to cover their expenses. The dot com bubble finally burst in March 2000, when the NASDAQ, a stock market index that was heavily weighted towards technology stocks, peaked and subsequently began a steep and dramatic decline. The crash lasted for several years, and the NASDAQ did not fully recover until a few years later in 2003. The dot com crash claimed many victims, some of which survived and some of which didn’t.
One example of a company that was significantly impacted by the dot com crash is none other than Amazon, which is now one of the most successful and well-known online retailers in the world. During the dot com bubble, Amazon's stock price soared to unprecedented levels, reaching a peak of around $106 per share in December 1999. However, the dot com bubble eventually burst, and many internet companies, including Amazon, faced significant challenges. As a result of the dot com crash, Amazon's stock price plummeted, and the company faced significant financial challenges. However, the company was able to weather the storm and eventually bounce back, and it is now one of the most successful and well-known companies in the world.
Other companies, however, were not as lucky. A famous example is that of Pets.com, which was a popular online retailer of pet supplies. The company was founded in 1998 and quickly gained widespread attention and investment, with its stock price reaching a peak of around $14 per share in early 2000. However, when the dot com bubble eventually burst, Pets.com, failed to live up to the expectations of investors. As a result, the stock price of Pets.com plummeted, and the company faced unsustainable financial challenges. In November 2000, the company announced that it was laying off almost 300 employees and closing its distribution center, eventually filing for bankruptcy in the same month Pets.com’s assets were eventually acquired and liquidated, becoming one of the many unfortunate casualties of the crash.
Needless to say, the dot com crash had a significant impact on the tech industry, as many companies went bankrupt or were forced to scale back their operations. It also had a broader economic impact, as the downturn in the tech sector helped to contribute to a recession in the early 2000s.
The dot com crash remains a potent reminder of the importance of careful investing and the dangers of speculative bubbles. It also demonstrated the need for companies to have sound business models and the ability to generate sustainable profits, rather than relying on hype and speculation.
How does the dot com crash compare to what’s happening today? Craft Ventures, led by David Sacks and Jeff Fluhr, led a discussion on this back in May of 2022 in a talk on how to operate during a downturn. A slide from their presentation compares the Dot Com crash with the Great Recession and the Post-COVID recession.
How is today different? It is important to note that the dot-com bubble was not caused by rising interest rates alone. The crash came as a the result of a complex set of factors, including the overvaluation of tech stocks, speculation, and a lack of understanding of the risks involved in investing in the tech sector (which was in its infancy at the time).While rising interest rates were not the main cause of the bubble, they certainly played a role in its collapse. When the Federal Reserve began to raise interest rates in 1999, it was in response to a strong economy and increasing inflationary pressures. Higher interest rates made it more expensive for companies to borrow money, which could have contributed to the decline in stock prices and the overall decline of the tech sector.
How does this trickle into current venture markets? According to data published by Wilson Sonsini: in early 2022, public market turbulence rocked technology stocks specifically, and the resulting decline in valuations may spill over into the private market and impact later-stage financings in particular. Following a record-breaking 2021 for the venture market, the first quarter of 2022 saw a cooling in the face of economic and geopolitical uncertainties.
Wilson Sonsini also found that down rounds continued to grow in Q3 2022, accounting for approximately 11% of Series B and later financings, compared to 7% in Q2 and 2% in Q1, which represented the largest share of down rounds in a quarter since Q2 2020, which was the beginning of the COVID pandemic. Pre-money valuations also took a plunge from Q4 2021, as indicated below:
Simple Agreements for Future Equity (SAFEs), which are popular among emerging companies due to their simple, largely company-favorable terms, saw some interesting statistics. The median amount raised via SAFE financings trended downward quarter-over-quarter, dropping from $1.2 million in Q2 2022 to $0.88 million in Q3 2022. In Q1-Q3 2022, 34% of SAFE financings included a discount, and the median discount was approximately 20%. 90% of SAFEs were pegged to a valuation cap, up from 86% in 2021, and the median valuation cap was $20.0 million, which indicates that SAFEs are being used primarily for early-stage financings. 24% percent of Q1-Q3 2022 SAFEs included both a valuation cap and a discount, and 23% used the “Most Favored Nations” form of SAFE, compared to just 15% in 2021, indicating that an increasing number of investors expect that the early-stage investing landscape could become more appetizing for investors in the coming year.
Eric Bahn, co-founder of Hustle Fund understands the position founders are currently in, having been a founder himself during a downturn prioring to being VC:
“I’ve got a lot of empathy for founders, who may be scared of the downturn ahead. I went full-time on my first startup right after Lehman Brothers collapsed in 2008, at the very start of the Great Recession, and it felt like the world was collapsing around me. What helped me then, and what I suggest to founders now, is to just have tunnel vision and don’t let macroeconomic or geopolitical news distract you. You probably started a startup because you wanted to build something great--and your business can and should thrive in good markets as well as bad. Focus on shipping and executing a product or service that people truly want and need. Make money. Even in the down markets, great companies can still get funded, but maybe you can also build a path to create a company that doesn’t rely on funding either.’’
Rachel Weiss of L’Oreal BOLD Ventures has also seen downturns in the market, and has the following advice for founders going through difficult periods:
“I have lived through downturns since the 90s. I have also seen great companies emerge from the toughest of times. My advice to founders is to be able to clearly express why you’re starting your company at this particular moment. Be obsessed with your customers and able to clearly express how you are solving their problems better than any of your competitors. I meet many founders who assume they don’t have any competitors but there is always someone who may have a similar pitch now or failed before so do your homework. Have a clear framework for what you want to build for today and for tomorrow.l and why the time is now. Context is always key and investors want to see passion.”
Jessica Peltz Zatulove, Founding Partner, Hannah Grey VC offers the following four valuable tidbits advice to founders that are struggling to navigate the existing landscape:
“Go deep spending time with your customers - does your initial value proposition still solve an urgent problem for them? Make sure you understand how their world has changed in this market - including their spending habits, life priorities, how they’re spending time, and pain points may have shifted from when you started the business. It’s critical to plan for how their purchase decisions could have changed coming out of the pandemic and going into a potential recession.
-When raising a pre-seed or seed round, set a valuation you can not only grow into - but 2-3x in ~6-18 months, which is what investors can expect. This past vintage valuations were exceptionally high at the early stage, founders will have difficulty growing into them which can put an additional strain on future financings - material business metrics vs. vision storytelling will be more at the forefront.
-Aggressively cash plan *early, and make necessary changes to reduce spending early. If/when you do want to raise an additional round of funding, you’ll want to do it from a position of strength (e.g. a minimum of 6 months runway) - the earlier you can course correct spend to stretch runway the more optionality you give yourself in the long run. Be transparent and lean on your investors to help you think through cost reduction strategies and scenario planning.
-Build relationships with investors early, the longer they’ve known you and have been following your progress, the more comfortable they will be writing a check when you’re ready. If you aren’t fundraising, considering time blocking a couple afternoons a month for investor check ins.”
Gale Wilkinson, Managing Partner at Vitalize VC, put forward the following advice in terms of operational strategy during a downturn:
“The best founders always focus on their north star, regardless of market cycles. What is your 5-year, big picture vision for your business? And what are the two or three quarterly goals that *most* help you get (or stay) on a path to hit your 1-year goals and ultimately that north star? In a tough macro-environment where both funding and revenue may be harder to get, founders have to double down: focus, prioritization, fast execution and iteration based on customer feedback. All resources and decisions should rally around those two to three most important goals. And it should be no surprise that finding product market fit is a critical area of focus for nearly all early stage startups!”
Garry Tan, founder of Initialized Capital and president of Y Combinator, has acknowledged that times are difficult right now for founders. Garry suggests that increasing runway by raising over the next few months is advisable; taking more dilution is far better than dying. Tan says, get to a point where you don’t need to raise even more to survive; cut marketing spend, cut hiring plans, and possibly induce RIFs (reductions in force).
Sequoia Capital in 2008 famously released a deck at the height of the financial crisis titled “RIP Good Times.” This deck has been in circulation lately and while it relates to a different time altogether (over a decade ago), many tidbits in the deck remain true even today, and have been referred to by venture capitalists frequently. In addition to examining important market dynamics of the time, the deck stresses the importance of product-market fit, and especially pushes a prioritized urgency in the quest to become profitable.
Jeff Fluhr and David Sacks of Craft Ventures: conducted a talk specifically on operating during a downturn in Q3 2022, where they suggest thinking about things in one’s control. They urge founders to be open to lower valuations if necessary, and adjust now to ensure a cushy 30+ months of runway, as Jeff predicts markets will still be choppy in the months to come. Modifying hiring plans, trimming items like sales and marketing spends unless there is near-term and quantifiable ROI, aiming for a burn multiple of 2 or lower are additional things founders should think about. As a positive note, Jeff says, “some of the most iconic companies were founded in recessions: Amazon, Salesforce, Airbnb, Stripe, Paypal, Google etc.”
Presentation by Jeff Fluhr and David Sacks
Marc Andreesen, co-founder of Andreesen Horowitz, has suggested engaging in contingency planning; as Marc puts it, “it’s a world of scenarios, not a world of predictions.” Marc also predicts a general tightening in the venture funding ecosystem: valuation prices resetting, retrenchment, funds allocating capital to existing portfolio companies that may re-raise, and funding rounds taking longer to close resulting in longer periods of diligence.
Paul Graham, co-founder of Y Combinator, famously wrote an essay called “Default Alive or Default Dead?” which, although it was published in 2015, strikes incredible relevance today. Graham writes: “Assuming their expenses remain constant and their revenue growth is what it has been over the last several months, do they make it to profitability on the money they have left? Or to put it more dramatically, by default do they live or die? Graham posits that a common way startups die is by making something moderately appealing and achieving decent initial growth; with this, the founders feel convinced that the way to growth is hiring, but again, with a moderately appealing product, their burn rate goes up and they quickly deplete runway, rendering them uninvestable for subsequent rounds, effectively killing the company. Graham concludes: “Asking whether you're default alive or default dead may save you from this.”
David Friedberg encourages founders to keep building, even in light of difficult market conditions:
“You know you could raise money at some crazy high valuation that's not always the best thing to do because then the expectation of the investors coming in at that valuation or they want to make three times that money or four times that money and it pushes you to do something unhealthy like spend more than you otherwise would stretch for a bigger outcome and put your entire company at risk so you know two things to me have always been just stay focused on building your business don't let - market conditions drive your decision-making and second define what for you is the best practice of staying focused on your business because that is a very general term(…)”
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