10 key lessons learned as a venture capital investor in the previous downturn

Published on 4 February 2020 by Pauline Wink on Linkedin

The Hague, The Netherlands - A recent article from Davos quoted Trump boasting about the US economy being the best it’s ever been. The graphs in the article went back to 2000 and clearly showed the impact of the 2008-2012 economic downturn on GDP growth, unemployment rate, household income and much more. As we all know, it wasn't pretty and brought back memories.

The economic downturn is a decade ago, but we do sometimes forget, particularly in a competitive and dynamic investing environment. I co-founded 4impact together with Ali Najafbagy about two years ago, as both of us wanted to use our experience, skills and network to contribute to positive change in the world. We invest in young companies that use digital technology to do good. But whether you invest in impact or not, being thorough and diligent in your investment decision and process is critical for success.

The venture capital market has certainly evolved since the last recession and the start-up ecosystem is thriving. Innovation and entrepreneurship are being cultivated and VC deal activity is up 3x in value (source: Pitchbook 2019 annual European venture report). However, as a venture capital investor making new investments, we make sure to take into account the potential implications of less favourable economic circumstances. And so should entrepreneurs. For this we draw upon experience.

During the last downturn I worked at one of Goldman Sachs' investing arms, which also invested in start-ups and growth capital. I witnessed the investment environment prior to, during and after the downturn. For venture capital this period was generally characterized by stressed teams and unpredictable behaviour, delayed decision making, lack of availability of funding, underperforming business plans and depleting cash reserves, which meant that these investments were tested to the maximum. Many companies were under severe pressure and subsequent funding rounds inevitable.

The below summarises 10 of the key lessons I learned as a venture capital investor during the last downturn.

1. Funding. Venture capital investments often need more funding as operational progress lags original plan on revenues but generally not on cost side. This is exacerbated during a down-turn. Be prepared (and able!) to fund more or be (massively) diluted.

2. Follow the money. (Token) contributions to subsequent funding rounds of lead investors can facilitate the attraction of new investors and continued support of smaller investors, and ensures stability. Lack thereof can result in failure of fundraising and in worst case scenario lead to dissolution of the company.

3. Management is key. Do extensive due diligence on key managers of future ventures. They ultimately make or break an investment. Do they have balanced and diverse skill sets with relevant experience? Do they have respect for capital and are they receptive to feedback? During a downturn, ensure that management keeps costs down and runs a lean business and where needed adjust incentive plans to have interests aligned.

4. Communication. Communication and information provision from the start-up to investors is vital and vice versa. This avoids negative surprises and allows investors to be best prepared to support the venture. It is a two-way street and to achieve result this requires trust and alignment between all parties.

5. Diligence. While there are countless questions you need to get comfortable with during diligence, important to note the following two as specifically relevant for a downturn analysis: understand unit economics and the road to (unit) profitability and get the full picture on payables to understand what amount of new equity is really available post investment to support the business.

6. Uniqueness. Ventures have a much stronger survival rate if their product / service / technology / IP solves a real need, is unique and difficult to replicate. Investors will flock to the best solutions and winners will prevail.

7. Third party reliance. Third-party funding such as vendor finance or bank finance can provide leverage to grow the business. However, if your initial investment, returns and investment success are reliant on the contribution of third-party funding this can lead to an unexpected cold shower. They can withdraw or renegotiate their financing resulting in a material delay in the plan and deterioration of the equity position.

8. Shareholder documentation. Difference in shareholder classes can create misalignment; this can obstruct capital raises or other situations where key decisions need to be made. In addition, too restricted shareholder agreements provide protection for an investor, but can also provide for other parties to block changes: sometimes more simplified governance between shareholders provides better protection and too restricted agreements can back-fire.

9. Shareholder composition. In good times, consider what the right shareholder composition is. As an existing investor (and as management) pro-actively seek new investors and understand their investment principles. Like-minded shareholders ease process and progress.

10. And finally, while difficult to accept and not the desired outcome, decide when to cut losses. Investing in start-ups is at the higher end of the risk spectrum. Some will perish, some will survive and some will come out as winners. Diversify!

See the article on LinkedIn here.

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