As the Managing Partner of MGV, Marc Schröder is focused on working with world-class tech entrepreneurs and establishing the MGV legacy.
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Given the recent change in the capital markets and startup investing climate, many fund investors and LPs are taking money off of the table and adopting a "wait and see approach" to future deployments of capital. The war in Ukraine, rising interest rates, inflation, the increasing likelihood of a global recession and declining equity prices all have investors seeing more risk than reward in the world right now. This is a scary time to put fresh money to work!
Investors have a duty to manage the capital they’ve been given wisely, and most fund managers are having a pretty hard time making a case for investing in pretty much anything right now. It’s the fund manager's responsibility to assess the risk they are exposing their LPs to and good fund managers take this responsibility very seriously, as they should. The other dynamic balancing this important consideration is that good investing is always about the long-term. When times are scary, that doesn’t always mean that stopping is the right move. Cost averaging is the name of the game, so when prices decline, it’s time to buy. As Warren Buffet said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
A Shifting Dynamic
Just months ago, founders had what seemed like unlimited access to cheap capital. They could dictate terms, demand lofty valuations and enjoy the fruits of bidding wars between investors. Those tables have since turned. Today, many founders are faced with short runways, rising costs and limited access to capital. Investors are now trying to squeeze founders on burn rates and valuations because the risk of deploying fresh capital has increased significantly.
Early-stage startups are almost always years away from profitability, so if you believe that the global economy will correct back to the established uptrend sometime over the next 3-5 years, this is actually one of the greatest times possible to invest in early-stage startups. Investor leverage has never been higher and we are able to secure deals in extremely promising startups at massive discounts. Additionally, these startups are getting smarter and stronger due to the current climate. Burn rates are suddenly in focus and paths to revenue and profitability are amongst the highest priorities. In the days of easy money, ‘growth at all cost’ was in vogue—the idea that you could grow a company to scale with limited revenues only to flip the switch of profitability once scale was achieved has since disappeared.
All great news for investors—the foundation being laid right now is going to give rise to some of the best companies. Establishing healthy patterns and processes around managing costs and achieving profitability is the best mindset an early-stage company could be born into. It’s giving rise to smart, realistic founders.
Founder Focus
One other thing that hasn’t changed in the early-stage venture is the key element of our business: founder focus. Investing in good founders is the name of the early-stage game and that won’t change under any economic conditions. Given the risk in the market right now, nailing this part of investing is what will set the winners and losers over the next decade in venture capital. Instead of chasing the hottest deals, VCs are dedicating more and more time to focusing their risk assessments around the Founder instead of who else is going to be on the cap table. This is great and an extremely healthy shift for our industry. The silver lining of the types of downturns we are currently experiencing is that it brings everyone — investors and founders alike — back to the fundamentals. Investors need to focus on investing in great founders (instead of chasing hype) and founders need to focus on building world-changing companies (instead of chasing the next massively overvalued around). The pain of this volatility is worth the price of admission.
The major risks of the early-stage venture aren't solely about losing capital on startups that fail, it's also about failing to deliver solid returns on that capital. Bad VCs lose money, mediocre VCs generate flat to moderate returns and the great VCs that go on to attract future capital deliver astonishing returns to their investors. Through this lens, the best VCs need to always be thinking about how they'll deliver outsized returns relative to their competition. Buying into great companies at times when valuations dip is the best way to do this!
The market is also showing us that these dynamics tend to be most concentrated and valuable in early-stage investing. The ‘Series A’ crunch is very real as companies emerge from the seed stages and are expected to start generating real revenues and gaining market share. This is much easier to achieve in bull markets when growth capital is available and enterprise companies are less margin-constrained. In our current environment, companies making the transition from seed to series A are between a rock and a hard place. Right now, they’re being forced to choose between taking a lower valuation in order to secure the capital needed to scale while simultaneously facing a shrinking base of capital. From the investor perspective, this transition carries with it significantly more risk than investing at the pre-seed or seed stage of a great company that has 1 or 2 more years of work to do before they’re ready to go start chasing the type of revenue and market share that’s expected.
As we go into 2023, I suspect that early-stage companies with great founders will still be able to attract the capital they need to keep building. Series A and beyond startups will continue to get crunched until some directional resolution comes into the capital markets. If you’re willing to deploy capital to great founders who are paying close attention to the fundamentals, you’re looking at a once- or twice-in-a-lifetime opportunity to create generational wealth over the next five to 10 years.
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