The Breakdown - Sequoia's Guide to Surviving the 2022 Bear Market

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, near NFTX, and produced and distributed by CoinDesk. What's going on, guys? It is Saturday, May 28th, and that means it's time for the weekly recap. Before we dive in, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or... If you want to dig deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also, a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX.

Starting point is 00:00:51 And finally, if you have not signed up yet, come get your tickets to CoinDesk's Consensus 2020. They're calling it the festival for the decentralized world. and what it does differently than other events is it covers all sides of the industry. It's really meant for a wide range of people with a wide range of interests, and there's something really cool about that type of cross-section coming together. The event happens between June 9th and 12th in Austin, Texas, so it's coming up right around the corner. It has tons of great speakers, tons of great sessions. And if you do want to join, head on over to coindesk.com slash consensus 2022,

Starting point is 00:01:28 and use code breakdown to get 15% off your pass. All right, it has been a dreary couple of days on the breakdown, not because we're getting depressed or sad or nervous or anything like that, but just because covering the mood and the emotion and the tenor of the industry has been rough. Yesterday, we talked about arriving in Goblin Town, and so today we're going to talk about how to survive your time here. We're actually going to zoom out, though, just a little bit from crypto specifically and talk about risk assets more broadly.

Starting point is 00:01:57 We're going to do so through the lens of venture capital. One of VC's favorite things to do is to open-publish the advice they give companies. It's that perfect combination of a public good, right? Non-cynically, these VCs have seen downturns before, so advice is useful. But it's also marketing for their firms. Jared Schwitzky, who is himself a VC, hilariously lampooned this on Twitter yesterday. No one, he writes, absolutely no one. Not a single soul.

Starting point is 00:02:26 25-year-old VCs. Navigating a downturn can be tough. Here are my seven tips for founders in 2022 and beyond. Jokes aside, the venture industry has been freaking the F out and sounding the alarm for months now. The tone coming from the industry has done a complete 180 from where things were last year when the main problem was not being able to deploy capital fast enough. BCs are urging their companies to cut costs, reduce burn, and the scariest concept of all for many startups become profitable ahead of schedule.

Starting point is 00:02:58 So today we're going to look at some of those recommendations and shifts, but it's worth giving a bit of larger context. And honestly, if you listen to the show yesterday, it's the same context you heard when I was discussing the fact that crypto was born after the last time we saw a major shift in monetary policy in 2008. Modern VC has been driven by the same forces. For more than a decade, an ever-growing amount of capital has been flowing into riskier assets. Now, critically, this isn't just more people waking up and thinking, hey, technology is awesome. Although, that's part of it. Mostly, though, it's a structural byproduct of low interest rates, making it harder to find yield in traditional areas, and so forcing asset managers of all stripes

Starting point is 00:03:38 farther out on the risk curve. As more money became available to venture capital and private equity, it meant both that more funds were started, but also that fund sizes got larger. This, of course, meant more money competing for deals, which also raised the size of rounds for tech startups and created whole new categories of late-stage private pre-IPO capital. that allowed companies to stay private longer. This, by the way, has had some interesting impacts around incentives. VCs make money in two ways, on fees and on carry. Fees are a percentage of the fund size that they make each year, regardless of performance, whereas carry is the percentage of the funds return that they get. A classic model is 2 and 20, 2% fees, 20% carry.

Starting point is 00:04:21 But that can vary a lot from firm to firm. One of the things you've seen a lot of in the last decade is this notion that funds basically never stop fundraising. You raise a $100 million fund, bag a few companies in early rounds that go on to raise at much higher valuations, and then you have yourself an implied return. Even though it's just on paper, the return profile of that first fund justifies raising a larger fund long before the portfolio companies in the first one ever actually reach an exit. There's nothing inherently wrong or immoral about this. Funds have an incentive, thanks to fees, to bulk up on AUM when people are willing to invest. I pointed out more as an interesting oddity of the last period. The one other structural oddity of a market

Starting point is 00:05:00 so awash in capital I'll point out is that there has been a growing discussion of the unsustainability of many venture-backed business models. One of the leading targets of this discussion is the on-demand industry led by companies like Uber. Basically, the gist is that a lot of these companies built themselves around a model where what early users were paying was effectively subsidized by venture capitalists. Charging $5 when the break-even price of the service was $10 was seen as a user acquisition cost. The question was always for how long could those models go on, and would they be able to transition to something more sustainable before the music stopped? The point of all of this is that a lot surrounding the venture industry over the last decade and a half has been shaped not by the venture

Starting point is 00:05:41 industry but by the larger macro context, which is perhaps why there has been such a visceral shift in tone over the last few months. It has read like folks who understood that something core and fundamental had changed. Let's take Lux Capital, for example. To their credit, they sniffed the shift sooner than most. In Q3 of last year, they wrote to their startups, have heightened humility in these seemingly good times. There is an observable excess of excess. Preparing for the turn when it comes is wiser than predicting when it may. We are aggressively capitalizing our companies and capitalizing on low cost of capital now. In Q4, they followed, be so well capitalized to be unfettered by fear and prepared to pounce. Do not invest in unprofitable growth into recessionary headwinds.

Starting point is 00:06:26 Finally, earlier this month, they described market sentiment as, quote, a mix of rapidly sobering shock as overconfident OK boomer greed turns to underappreciated how is this happening fear. What we witnessed was a market out of balance, and we talked of crowd sentiment going from fear of missing out, to shame of being satisfied, to pride of losing less. Both profound and poetic. Looking for ways to step up your crypto game, then go with Nexo.

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Starting point is 00:08:02 with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Let's move to our main focus, Sequoia. Sequoia, for those of you who are not deeply in the world of venture capital, has been around forever.

Starting point is 00:08:38 They made their name investing in Apple in 1978 and have a long history of these sort of letters. In 2008, they published a famous presentation called RIP Good Times. The 56-page document went through their explanation of how things had gone so wrong over the last couple years and new realities in what it might mean. Those new realities included that the $15 million raise at $100 million post-money valuation is gone, that series B&C would be smaller raises, that customer uptake would be slower, that cuts are a must, and that there was an important need to become cash flow positive. Interestingly, from a full historical perspective, that 2008 letter also included in April 2000 email that one of their partners had sent portfolio

Starting point is 00:09:22 companies during the dot-com bust. That email read, the downdraft in the stock market sends us some obvious signals and we can't help but mention them. If you are in a funding cycle, you should raise your funding as soon as possible and raise as much as possible. You must aggressively examine and pursue M&A opportunities unless you have over 12 months of cash reserves to ensure you have critical mass. Be realistic on valuations. They will fall, so be ready and willing to cooperate. While it's safe to say entrepreneurs have had negotiating leverage with the downdraft in the market, the VC community will start exercising their leverage. So you have 2000, 2008, and yes, then they did do a Corona Black Swan memo, which had similar thoughts,

Starting point is 00:10:00 although the X factor there was that it was such a new type of phenomenon that they really weren't sure what advice to give. The point is, this is a thing that Sequoia does, and so let's see what they're saying this time around. I think if I had to sum it up, it's that what's happening now represents a phase shift, not just a small change. They write, we're experiencing the third largest NASDAQ drawdown in 20 years. Sixty-one percent of all software, internet, and fintech companies are trading below pre-pandemic 2020 prices. They've lost more than two years of stock price appreciation. That's despite many of these companies more than doubling both revenue and profitability. The market is clearly indicating that the valuation framework over the last two years is no longer

Starting point is 00:10:41 relevant with the removal of free money. And I think this is a really key part of the discussion. What Sequoia is talking about is not multiple compression or just reevaluation of growth and profits. It's a fundamental rethinking of how companies are valued and which metrics are relevant compared to past times. What's more, they're identifying that it is, in fact, the removal of free money, their words, that is the core issue. They go on. With the cost of capital, both debt and equity rising, the market is signaling a strong preference for companies who can generate cash today. Unlike prior periods, sources of cheap capital are not coming to save the day. And this gets back to what we were talking about earlier with the secular shift in markets.

Starting point is 00:11:26 Sequoia is really discussing the rise in both the cost of and scarcity of capital. The higher the yield of risk-free assets like government bonds goes, the less capital is available for traditional risk assets. But there's also a shift in investor goals, moving from a mentality of maximizing return to one of minimizing risk. So with this change, who will be successful? The way that Sequoia describes it is this. When capital was free, the best performing companies were capital consumptive. As capital has gotten expensive, these have become the worst performing companies. Growth at all costs is no longer being rewarded. This is exactly what we were talking about before, where in the old paradigm, companies were raising more to acquire users even if it wasn't

Starting point is 00:12:10 a sustainable business model, because that was something they could figure out later. More and more, that seems not to be an option, or at least not rewarded in public markets. Now, if they're right, this isn't an incremental change. It's about flipping which sort of companies perform on its head. We've lived in a macro environment where the best startup strategy was to consume capital to purchase growth, but now that's all changing. It seems to be that startups are being called upon to switch from being net consumers of capital to net producers of capital. So what is Sequoia's advice? Well, one, must be adaptable. Two, companies who move the quickest will have the most runway and are most likely to avoid the death spiral. Three, what decisions do you

Starting point is 00:12:48 plan to make and what decisions do you wish you had made? When you have just six months of cash left, focus becomes incredible. Get that focus now regardless of how much you have in the bank. And four, finally, there is opportunity ahead. Recognize it. So as we wrap this up, I thought Joe Wisenthal of Bloomberg pointed out something interesting. He wrote, Every several years, we get a new round of VCs telling portfolio companies to hunker down and save cash. But what's new about this time is that the risks seem all about a tighter future fundraising market, as opposed to some big economic collapse. The economy might be wobbly right now, but that's not really the issue. It's mostly just a funding story. I think in this,

Starting point is 00:13:27 Joe gets at what really the key question is here. Holding aside all the admonitions to just survive and keep cash tight and yada yada. What are the odds that, one, inflation is tamed and recession is either the cause of the taming or the result, the Fed shifts back to accommodative again ushering back in the cheap money era. Versus two, there is a larger reevaluation of capital deployment that doesn't return back to so much money for risk. This isn't just a question with relevance for venture capital. Obviously, it could impact who is in the crypto markets as well. I believe as the summer sets in, and as we get the 50 basis point hikes that seem entirely baked in at this point in June and July, much of the speculation will shift slightly longer term. The debate will be how much tightening the Fed can

Starting point is 00:14:13 really do. What sort of structural risks the economy faces? How far the Fed can afford to let the stock market fall? We'll debate it and debate it and debate it and then something will happen. But what that's something is, we can't know till then. For now, I want to say thanks again to my sponsors nexus nexus.io, near and FtX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. Hey, breakdown listeners, come join CoinDesk's Consensus 2020, the festival for the decentralized world this June 9th through the 12th in Austin, Texas. This is the only festival showcasing and celebrating all sides of blockchain, crypto ecosystems, Web3, and the Metaverse, and is designed for crypto-newbies, investors, entrepreneurs, to

Starting point is 00:15:03 developers and creators. Use code breakdown to get 15% off your pass at coindesk.com slash consensus 2022.

The Breakdown - Sequoia's Guide to Surviving the 2022 Bear Market

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