Venture capitalists are singing a different tune amid a widespread market meltdown. Blitzscaling, lighting cash on fire, and delusions of grandeur are out; capital efficiency, solid unit economics, and otherwise boring businesses are in.
The effects of rising interest rates and recessionary fears have snuck their way into the technology industry, where venture capitalists are turning away from the exuberant and costly scale-at-all-costs strategies made famous in the 2010s by companies like WeWork and Uber and taking a novel approach: finding businesses that can make money than they spend.
“The world has shifted,” said Sheel Mohnot, a San Francisco-based venture capitalist focused on early-stage startups. “We are now in an era of profitability.”
Monhot said his firm is now targeting companies that have a clear path toward positive cash flow and guiding his own portfolio companies toward sustainability. Others said the same. “On our end, we've been even more focused on unit economics day 1 when we invest,” said TX Zhuo, a general partner at a Los Angeles-based firm.
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Over the previous decade, investors reportedly plowed $1.3 trillion into startups, many of which were growing quickly and dramatically but had yet to discover viable business models. The fast-flowing venture capital allowed a select group to throw money around, inorganically acquiring customers and overwhelming competitors in search of a monopoly that would eventually allow them to cash in.
Uber subsidized car rides, MoviePass let people go to the movies for next to nothing, and ClassPass roped customers in by offering below-market exercise classes. In the same way, the massive funding also allowed WeWork to become New York City’s largest tenant and Uber and Airbnb to carry out a series of lawsuits as they attempted to undercut cab laws around the world.
In the process, a lack of financial discipline started to permeate throughout the tech sector. By 2018, money-losing startups were going public at the highest rates on record, according to data compiled by one University of Florida finance professor. In the two years after that, more than 90 percent of billion-dollar U.S. startups were reportedly losing money.
“It created the ultimate hall-pass for outlandish dreams,” said Peter Atwater, a lecturer in economics at the College of William & Mary who studies confidence-driven decision making.
This environment was in large part fueled by lowered interest rates in the aftermath of the financial crisis, which plowed cheap, easy money into the economy. From the perspective of venture capitalists, that made the cost of capital cheap enough to allow them to make large, long-term investments with less concern. Any company could theoretically appear to become the next Amazon—an unprofitable business on the precipice of dominance if given enough funding and time.
“Low interest rates mean you can bet on the future,” said Monhot. And investors did bet big. Valuations and investment rose to record levels, reaching a climax last year. Entrepreneurs found themselves with newfound leverage in negotiations, as investors competed with one another to get in on rounds, in the process offering quick, inflated deal terms and less diligence and oversight.
Then, last year, inflation started to rise, and the Federal Reserve decided to clamp down by raising interest rates, which it hoped would cool the economy and stabilize prices. Just like that, the party in Silicon Valley seemed to end. Layoffs hit, companies enacted hiring freezes, and venture capitalists suddenly started to rethink how they did business. “Investor sentiment in Silicon Valley is the most negative since the dot-com crash,” venture capitalist David Sacks wrote on Twitter in May. The amount of cash raised almost halved in the first quarter, and the total number of deals both dropped by more than a third, according to the equity management company Carta, which tracks more than 28,000 companies. That pattern has continued into the second quarter, according to early analyses.
Late-stage startups have suffered the most so far, but rising interest rates have had a dramatic effect on the types of startups that early-stage venture capitalists are targeting as well, they told Motherboard. “The math on what you invest in has to change,” said Monhot. “There's some businesses for which this new world doesn't really work.”
As a result, businesses that looked appealing six months ago suddenly look like too much of a risk. Venture capitalists told Motherboard that unit economics, smart spending, and tangible business models have replaced theoretical promise and an ability to scale by scale by spending money as attributes worth targeting.
“VCs have rediscovered what margins and cash flow are,” Logan Bartlett of Redpoint Ventures told me. "Right now high growth is out of favor and capital efficient is in favor,” said QED Investors’ Frank Rotman. Dan Abelon of Two Sigma Ventures said, “Many in the industry were allergic to the term cash flow positive especially for early stage startups, until the last few months.” And those are just a smattering of the comments I heard from VCs.
Venture capitalists often see themselves as the smartest people in the room, a steady hand guiding founders with wisdom and clarity, so it is no surprise that many of them said that they are stable and have not changed their own approach, which, they promise, was always solid. “We're certainly in a better position than many other funds, or maybe most funds,” Mohnot said. “But it's possible that everyone thinks that about themselves.”
When they look outward, though, they are newly searching for signs of sanity. Kat Wilson, the managing director at Miami Angels, a Miami-based angel investor network, has been telling her members to pay extra close attention to companies that “have a path to profitability” and are not so dependent on the next round of venture funding. She is looking for trackable metrics and signs of financial prudence, including cost cutting where necessary. Often, these are more traditionally “boring” and “unsexy” startups, not experimental Web3 startups with unproven use cases, according to Wilson.
“Something that's a good, solid business is now even more attractive,” she said. “Just show that you are a real business, not a built-for-financing business.”
None of this means that venture capitalists are suddenly looking at mom-and-pop shops as good investments. Their eye for profit at the lowest possible cost is merely shifting to other—seemingly more stable—areas, where the staunch flow of cash actually gives VCs more leverage. “Growth is still the name of the game for venture. But there's going to be a bigger emphasis on unit economics, being prudent with your money, and being thoughtful about your customer acquisition,” said McKeever Conwell, a venture capitalist based in Maryland.
In the new high-interest environment, many venture capitalists are targeting lean software businesses that don’t “require expensive IRL logistics,” said Josh Constine, a venture partner at an early-stage fund and the former editor-at-large of TechCrunch. That means companies that require a lot of money to operate—say, a Peloton—“are falling out of favor quickest,” said Eniac Ventures’ Hadley Harris. That could hurt businesses that are attempting to develop more complicated but potentially transformative technologies. It also means that expensive companies that spend a lot to earn customers will struggle quickly, as has already been the case already with fast delivery startups like GoPuff.
“In a 2021 exuberant world, you could burn a lot of money on customers,” Mohnot said. “In 2022, it's a very different story.”
Sustainable businesses become more enticing in periods of economic uncertainty because of the chance that funding will not be there to keep an unprofitable startup afloat, a question that few were asking as recently as last year, some said. In such an environment, venture capitalists are wondering if a company can last without receiving funding every six months to a year. “They weren't even asking that question a year or two ago,” said Richard Lyons, the chief innovation and entrepreneurship officer, UC Berkeley and former dean of the business school. Four venture capitalists said they are asking startups if they can sustain themselves through the end of 2023 without additional funding.
One of them is Conwell, who said he has suggested to founders that they raise money that gives them a 24-month runway to ride out this period of turmoil. But founders don’t always agree. He recently got in an argument with one such founder who said they planned to burn through the available funding in months and then go raise again, as was the norm in recent years. Conwell said to the founder, “I don't think that's the best plan,” he told Motherboard.
Still, the money is there, and investors have to invest it.. “So many VC funds have the money to deploy,” said Meagan Loyst, a venture capitalist at Lerer Hippeau and the founder of Gen Z VCs. Loyst, for her part, has been trying to emphasize to entrepreneurs that her firm has plenty of money to dole out, even if they are also “going back to the fundamentals,” by putting more emphasis on valuation and metrics. “There's so much fear in the market right now,” she said.
The new state of affairs has actually benefited venture capitalists, sources said. By last year, the large amount of money in the startup ecosystem led many venture capitalists to have to compete with one another to invest in startups, handing increased leverage to the entrepreneurs, who sometimes felt like they could name a number and get that amount of funding. Now, that has started to shift as venture capitalists become more picky.
“Things being easy for the entrepreneur and being very founder friendly aren’t going to be the standard anymore,” said Conwell, who expects the shift will be difficult for young entrepreneurs who grew up in the easy-money era. “It's gonna be really upsetting to them.” According to Carey Smith, a venture capitalist in Austin, entrepreneurs "are a little bit more concerned, which is fine, because that just gives us more leverage. That's always a good thing from a business point of view."
Money is at the heart of the issue, as it always is in the venture industry, and Conwell said the renewed emphasis on unit economics is necessary in the new world, where money is more expensive and investors everywhere will look closer for cracks in the business.
“We can't afford for you to not have good unit economics,” Conwell said, “and us miss out on getting returns.”