Market Update from Jamie Weston
As an investor, there can be many ups and downs over a year or even within a month. With this in mind, I was listening to one of my favorite podcasts a few weeks ago – The All-IN Podcast – and was interested in their open and frank discussion around portfolio issues. Regardless of the stage, geography, or segment, no portfolio is immune to the challenges caused by current market conditions – be it softness in enterprise demand for your products, the related change in valuation frameworks or otherwise.
Over the last several years, market conditions for equity investments and venture capital have generally been favorable. We experienced an unprecedented period of loose monetary policy that produced a prolonged period of zero interest rates and negative real interest rates. The global economy was strong and expanding, supported by a boom in technology and innovation. As a result, investors were driven further out on the risk curve with fewer options for returns.
Equity capital became both cheap and abundant. Fundraising was relatively easy. The valuations for public and private growth companies grew to record levels. Startups were embraced by both receptive IPO and M&A markets. This created an ideal greenhouse that gave birth to a new breed of venture capital. The venture capital ecosystem, particularly in the Silicon Valley, New York, London, and Shanghai hotspots, aligned around cultivating “unicorns” – startups valued at over $1 billion. The name of the game became “growth at all costs,” which demanded spending and hiring aggressively, generally well ahead of expected growth. You had the luxury of circling back later to fix excessive cash burn or off-kilter unit economics. This strategy worked as long as capital continued to be cheap and abundant.
What a difference a year makes. To tame inflation, the Federal Reserve and other central banks aggressively hiked interest rates within an unprecedentedly short period. Money is no longer free. Because the value of any asset is the discounted value of its future cash flows, higher interest rates mean higher discount rates that, in turn, reduce the value of future cash flows. In short, growth today is worth less. As a direct result, the record valuation levels for growth companies have peaked, as has new deal volume. The greenhouse conditions fueling the unicorn strategy ended abruptly, and a new paradigm emerged.
We are now back to a world with a real capital cost. By necessity, venture capital investors are adjusting to what we would call the “old normal.” This market adjustment can be seen in the noticeable slowing of commitments to new venture investments and the longer time to diligence the deals being done. Today, margins of error are being built into valuations because of the uncertainty of whether valuation levels have yet stabilized. Similarly, many investors are extending their projected holding periods to account for uncertainty about when the IPO and M&A exit markets will re-open.
This new economic reality calls for a different mindset and ethos for startups. The new metaphor is the “camel.” It may not be very flashy, but it’s quite apt. The watch words for the camel strategy are sustainable growth, a path to profitability, and capital efficiency. Integral to this strategy is the careful management of expenses and cash burn, with the guardrails being healthy unit economics and positive ROI on spending. Greater capital efficiency enables a more disciplined external funding strategy. Like the camel, a startup wants to be resilient and control its destiny.
Investing over cycles tends to imbue a strong sense of humility. Regardless of whether the highs are high or the lows are low, it’s important to continue to adhere to our process of evaluating themes and companies and maintaining confidence in knowing the work we’ve done constructing portfolios will withstand the test of time. The fundamentals underlying the camel strategy have always guided SMC’s investment choices. We attempt to balance big potential opportunities with a disciplined investment underwriting process. On one side, we find companies that operate in big white spaces, as measured by the size of the TAM (or total addressable market), and have demonstrated high growth, employing a recurring revenue business model. On the other side, we evaluate companies against the yardsticks of healthy unit economics, capital efficiency that comes from the careful management of cash burn, the strength of the management team, and a reasonable path to profitability.
As investors, we are thoroughly excited about the future - both for our existing portfolio partnerships and the new ones we look to create.