Start-up investors are warning of dark days ahead as boom times are 'unambiguously over'
Sentiment has changed dramatically from last year, when a frenzied pace of deal-making, sky-high valuations and wild venture spending were the norm.
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Slow your hiring! Cut back on marketing! Extend your runway!
The venture capital missives are back, and they're coming in hot.
With tech stocks cratering through the first five months of 2022 and the Nasdaq on pace for its second-worst quarter since the 2008 financial crisis, start-up investors are telling their portfolio companies they won't be spared in the fallout, and that conditions could be worsening.
"It will be a longer recovery and while we can't predict how long, we can advise you on ways to prepare and get through to the other side," Sequoia Capital, the legendary venture firm known for early bets on Google, Apple and WhatsApp, wrote in a 52-page presentation titled "Adapting to Endure," a copy of which CNBC obtained.
Y Combinator, the start-up incubator that helped spawn Airbnb, Dropbox and Stripe, told founders in an email last week that they need to "understand that the poor public market performance of tech companies significantly impacts VC investing."
It's a stark contrast to 2021, when investors were rushing into pre-IPO companies at sky-high valuations, deal-making was happening at a frenzied pace and buzzy software start-ups were commanding multiples of 100 times revenue. That era reflected an extended bull market in tech, with the Nasdaq Composite notching gains in 11 of the past 13 years, and venture funding in the U.S. reaching $332.8 billion last year, up sevenfold from a decade earlier. according to the National Venture Capital Association.
The sudden change in sentiment is reminiscent of 2008, when the collapse in the subprime mortgage market infected the entire U.S. banking system and dragged the country into recession. At the time, Sequoia published the infamous memo titled, "R.I.P. Good Times," proclaiming to start-ups that "cuts are a must" along with the "need to become cash flow positive."
Sequoia Capital Global Managing Partner Doug Leone speaks onstage during Day 2 of TechCrunch Disrupt SF 2018 at Moscone Center on September 6, 2018 in San Francisco, California.
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However, Sequoia hasn't always nailed the timing of its warnings. In March 2020, the firm called the Covid-19 pandemic the "Black Swan of 2020" and implored founders to pull back on marketing, prepare for customers to cut spending and evaluate whether "you can do more with less."
This time around, Sequoia's words look more like the emerging conventional wisdom in Silicon Valley. The market started to turn in November, with companies going public trickling to a halt to start 2022. The crossover funds that fueled so much of the private market boom have pulled way back as they grapple with historic losses in their public portfolios, said Deena Shakir, a partner at Lux Capital, which has offices in New York City and Silicon Valley.
"Companies that recently raised at very high prices at the height of valuation inflation may be grappling with high burn rates and near-term challenges growing into those valuations," Shakir told CNBC in an email. "Others that were more dilution-sensitive and chose to raise less may now need to consider avenues for extending runway that would have seemed unpalatable to them just months ago."
In its first-quarter letter to limited partners, Lux reminded investors that it had been predicting such trouble for months. The firm cited its fourth-quarter letter, which told companies to preserve cash and avoid putting money behind unprofitable growth.
"Our companies heeded that advice and most companies are now prepared for winter," Lux wrote.
Sustained increases in fuel and food prices, the ongoing pandemic and raging geopolitical conflicts have collided in such a way that investors now fear out-of-control inflation, rising interest rates and a recession all at once.
What's different this time, according to Sequoia's presentation, is there's no "quick-fix policy solution." The firm said that what it missed in early 2020 was the government's aggressive response, which was to pour money into the economy and to keep borrowing rates artificially low by buying bonds.
"This time, many of those tools have been exhausted," Sequoia wrote. "We do not believe that this is going to be another steep correction followed by an equally swift V-shaped recovery like we saw at the outset of the pandemic."
Sequoia told its companies to look at projects, research and development, marketing and elsewhere for opportunities to cut costs. Companies don't have to immediately pull the trigger, the firm added, but they should be ready to do it in the next 30 days if needed.
Job cuts and hiring freezes have already become a big story inside major public tech companies. Snap, Facebook, Uber and Lyft have all said they would slow hiring in the coming months, while Robinhood and Peloton announced jobs cuts.
And among companies that are still private, staff reductions are underway at Klarna and Cameo, while Instacart is reportedly slowing hiring ahead of an expected initial public offering. Cloud software vendor Lacework announced staffing cuts on Friday, six months after the company was valued at $8.3 billion by venture investors.
"We have adjusted our plan to increase our cash runway through to profitability and significantly strengthened our balance sheet so we can be more opportunistic around investment opportunities and weather uncertainty in the macro environment," Lacework said in a blog post.
Tomasz Tunguz, managing director at Redpoint Ventures, told CNBC that many start-up investors have been advising their companies to keep enough cash on hand for at least two years of potential pain. That's a new conversation and it goes along with tough discussions around valuations and burn rates.
Shakir agreed with that assessment. "Like many, we at Lux have been advising our companies to think long term, extend runway to 2+ years if possible, take a very close look at reducing burn and improving gross margins, and start to set expectations that near-term future financings are unlikely to look like what they may have expected six or 12 months ago," she wrote.
In a post on May 16, with the headline, "The Upside of a Downturn," Lightspeed Venture Partners began by saying, "The boom times of the last decade are unambiguously over." Among the sub-headlines, one reads, "Cut Non-Essential Activities."
"Many CEOs will make painful decisions in order to keep their companies afloat in choppy waters," Lightspeed wrote. "Some will face trade-offs that only a few months ago would have seemed outlandish or unnecessary."
Lux highlighted one of the painful decisions it expects to see. For several companies, the firm said, "sacrificing people will come before sacrificing valuation."
But venture firms are keen to remind founders that great companies emerge from the darkest of times. Those that prove they can survive and even thrive when capital is in short supply, the thinking goes, are positioned to flourish when the economy bounces back.
For companies that can add talent today, there's more available because of hiring freezes at some of the biggest companies, Sequoia said. And Lightspeed noted that technology will continue to progress regardless of what's happening in the market.
"Despite all the talk of doom and gloom, we continue to be optimistic about the opportunities to build and invest in generational technology companies," Shakir said. "We've been heartened to see our CEOs exchanging notes and tips with one another, at once energized and humbled by these changing conditions."
CORRECTION: This story was updated to reflect that cloud software vendor Lacework raised $1.3 billion in growth funding at a valuation of $8.3 billion.