Venture Investing in 2023
Last year I wrote this post on Venture Investing in 2022. At the time, some of the public tech stocks had started to fall in value (Docusign, Doordash, Twilio etc had all taken some pretty big hits). However, venture markets were still hot, rounds were still closing, and we were just approaching the cliff that hit early stage markets in Q2/Q3 of 2022.
The basic points I made were:
Valuations should be higher than they used to be, but not this high
The companies that were most expensive were the ones that were easy to understand (SaaS)
The companies we were focused on were not really seen as “venture” so whereas it was hard to raise follow on rounds for them, we didn’t take as much valuation risk
I’m pretty proud of that post as, in hindsight, I think we kind of got it right. But we also might have been lucky, so I’ll try to frame how we’re thinking about 2023, especially in terms of how it differs from our approach at the beginning of 2022.
The main change is that risks are different now. Before 2021, the biggest risk we could take was that we’d enter a good company at the wrong price. We reacted to that by investing in esoteric companies, or companies in spaces that were unloved. We weren’t afraid of these contrarian companies’ ability to raise money because the market was hot. We did contrarian deals at less expensive valuations and were willing to take funding risk.
Now, our biggest risk is that we invest in a company that’s too contrarian that no one will do the next round - especially since markets are cold. We’re also unafraid of valuations now (or less afraid). This means we’re looking for consensus companies likely to raise follow on rounds, and we’re fine with the bets being less contrarian because the prices aren’t terrible anymore. In short – we’re fine taking beta exposure to this vintage so long as our companies don’t suffer because they can’t fundraise.
So how do we mitigate fundraising risk?
Invest in semi-consensus business-models (like SaaS)
Invest in companies with short feedback loops: Before 2022 companies were funded based on narratives. Now, they raise based on data. Backing companies with long sales cycles, or hefty tech builds is scary because they may not show financial transaction in time for their next round. We are looking for companies with quick feedback loops who can show business progress quickly.
Companies that can control their own destiny: Finding companies who can generate cash within 2-3 venture rounds allows us to back companies that rely less on capital markets. If markets are good and they can raise equity as an accelerant, great, but we don’t want that to be a requirement. It used to take ~10 years for companies to reach $1B in value. That timeline got crunched into 3-5 years during 2020-2021 and we think it’ll start going back to 10 years - and we’re fine with that.
We’re also changing the makeup of how we deploy our fund capital. During a hot market we try to weight our portfolio more towards new checks than towards follow ons. This is mostly because growth markets are more efficient than early stage markets are, and therefore the rounds are generally too expensive. We also don’t need to reserve as much to play defense on companies we really liked because the market was so hot that any company not raising its follow on round probably didn’t deserve a bridge round either.
Now – we’re reserving more for follow-ons to play defense when needed, and because follow-on rounds won’t be too expensive to participate in.
We’re also going to diversify the portfolio a bit more. During cold markets we try to diversify and during hot markets we stay concentrated? Why – because the more deals you do, the more likely it is you will be earning a representative return profile relative to the rest of the vintage. In a hot market where we don’t want beta exposure and there are less deals that we like, we do less deals and are more concentrated.
In a market like this, where we are optimistic about vintage performance, we don’t mind investing in more deals per fund to ensure we catch as much of the wave as we can. We don’t need to pick and choose our spots as strictly in a market like this, where the entry valuations are better at compensating for the risk being taken.
We’re also less likely to sell secondaries than we were previous to 2021. In 2021 we sold secondaries in three of our older investments and looking back, these were probably the only three opportunities we had during that year to sell, and we hit the bid each time. But now, most opportunities to sell secondaries are challenging. I do think “selling secondaries” is an important and under-utilized toolkit for investors. And it’s something we’ll always at least consider, but I bet we don’t accept every offer we get this year, like we sometimes did in the past.
Finally, we have a few “why now” theses we’re exploring.
What new forms of employment will be created as a result of work-from-home preferences, and tech layoffs? In our last vintages we focused on the AMZN TPS economy, YouTube economy, Shopify economy etc.
If I had to guess, I bet a lot of the new jobs being created will be information-based jobs – simply because they’re remote, and partially due to layoffs, the workforce newly available is highly educated.
We’re also excited to invest more heavily into residential real estate, which is likely going to see headwinds, making it an attractive market to slowly allocate into over 2023, 2024 and 2025. We’re paying attention to what other cyclical waves we can ride – and are open to ideas.
2022 was a pretty brutal year of changing course, adjusting growth plans, and often having to reduce costs - and it doesn’t quite feel like we’re at the bottom just yet. But I wouldn’t be surprised if we start to get increasingly active towards the end of this year, and into 2024.