As the pendulum swings, it’s important to assess where venture capital stands and how investors may approach it in both the near term and the future. As someone who has witnessed down markets, up markets and everything in between, below are some core ideas worth considering.
History shows that down markets are the best time to invest.
History has repeatedly shown that down financial market cycles can be great times to invest in new startups. Deal valuations adjust to sensible levels, the pace of investing slows down, relationships matter and talent is more available. We can build businesses one brick at a time with capital efficiency. By the time the markets come back, many companies are then poised for exits and distributions.
We’ve been through this market cycle before.
I have been part of the Silicon Valley venture capital community for over 30 years. The first deal I worked on was the seed investment in Sun Microsystems. Since then, I have seen the good, the bad and the ugly in Silicon Valley from the dot-com bubble bursting to the global financial crisis, to the massive influx of capital from the Vision Fund and the barrage of investing from Tiger Global and other new entrants. The movie has always been the same—the financial markets heat up over time, becoming frothier and frothier until venture deal valuations reach absurd levels, and then, when the music stops, everything unfolds quite precipitously often accelerated by unforeseen events.
As we all know, the music stopped in 2022 with the advent of inflation and rising interest rates, and sadly the perfect storm surrounding SVB has further strained an already tenuous Silicon Valley environment.
In the short term, there will be a lot of pain.
The startup world will bifurcate between the deserving and the undeserving. Significant amounts of capital have come into the venture capital asset class and created a vast number of overvalued companies that will need financing. Venture debt will be less available to help companies that need to course correct. Companies that have low-margin business models and rely on large amounts of capital to succeed will face great difficulty. Cram-down financings and startup mortality will become far more commonplace.
Innovation is independent of market cycles.
People fail to realize that regardless of where we are in the business cycle, innovation comes in waves that are independent of market ups and downs. For this reason, there is always a significant number of well-considered, venture-backed companies that thrive. These are the startups based upon differentiated, compelling value propositions that maintain discipline, building their businesses with capital efficiency and growing even through challenging markets. They are always in demand by investors and attract capital at significant premiums.
Among them are the anomalies that become future market leaders with enduring value, and this is what venture capital is all about. We refer to them as the needle movers, and for our LPs, these are the companies that drive fund-level returns.
Without question generative AI represents a generational wave of innovation that will create massive opportunities. One can only imagine its enormous impact. There will be venture-backed companies that are AI adopters, AI-native or AI enablers that will become the needle movers of the future.
The venture capital industry is already adjusting.
I’ve had the pleasure and privilege of working with many of the most skilled venture capitalists of our time as a co-investor and at the board level. I can speak firsthand of their talents and drive to build great new companies. As the dust settles, I am seeing these investors moving rapidly to set themselves up for success for the next cycle. In particular, the best venture firms are returning to an earlier-stage focus, which is very exciting, because this is where they can most uniquely apply their exceptional investment talent.
Truly talented venture capital investors work collaboratively within their teams with prepared minds and unique instincts to identify investment opportunities well ahead of conventional market research. They recognize the vision of extraordinary entrepreneurs to address new ideas that can be developed beyond point solutions into real platforms that will have huge impact in their respective industries. And they also possess the company-building skills to help entrepreneurs shape great company outcomes. Working together to take a startup to a multibillion-dollar business is no easy feat, and successful venture firms do it repeatedly.
Why a healthy venture capital industry is important.
Venture capital is fundamentally about recognizing the need and opportunity for addressing change. It can be a force for good to address a wide range of challenges from healthcare to cybersecurity to climate change. It can reshape existing industries and create new ones that don’t exist today. It is strategic to our global competitiveness and an irrefutable engine for job creation and economic prosperity.
Originally published on Forbes.