Eight years ago, Silicon Valley venture capital powerhouse Sequoia held a private meeting with its portfolio companies offering key instructions on how to weather the coming economic crisis. The presentation from that meeting — famously titled “RIP: Good Times” and featuring those words somberly placed on a tombstone — set off warning bells throughout the industry that things were about to get really nasty.
With the economic winds changing once again and many forecasting stormy skies ahead, Seattle venture capital firm Madrona Venture Group penned a letter to its investors — university endowments, charitable foundations, angel investors and others — offering its own advice on how startups should navigate these uncertain times.
And while Madrona’s memo lacked the grim imagery that Sequoia employed in 2008, the message from the venerable Seattle venture capital firm was clear: Batten down the hatches and focus intently on what you can control.
“Capital markets are under pressure, which is impacting later stage valuations, IPO timing and potentially acquisition markets,” according to a copy of the Madrona letter which was shared with GeekWire. “What should venture-backed companies, in this more challenging macro environment, be focused on now? We have found the key is to focus on what can be controlled and to be intentionally informed about what can’t be directly controlled.”
Madrona, which celebrated its 20th anniversary and raised a $300 million fund last year, has encountered tough times before. It was around during the dot-com bust of 2000-2002 and the global financial crisis of 2008-2009. In the letter, Madrona said that those eras were “especially instructive” and that many companies from the last economic recession “emerged stronger when the economy rebounded.”
And while that may very well be the case, the letter from the firm that backed the likes of Amazon.com, Isilon Systems and Sharebuilder should give entrepreneurs pause (or at least something to ponder).
Many venture capitalists and startup leaders have spoken of a coming bust — or at least cooling period — in recent months.
At GeekWire Startup Day earlier this month, VCs and angel investors shared tips for surviving a downturn, and nearly all of the panelists agreed that the venture financing climate is softening.
Here’s the full Madrona letter:
Focus on What You Can Control
The 2015 calendar year is in the books and the first few weeks of a new year are always a mix of analyzing the prior one and finalizing the operating plan for the coming year. But, a rough start to 2016 on several macro fronts – including Chinese stock market and currency declines, oil prices dropping below $30 a barrel and a 15%+ correction in most U.S. equity markets – has led to a more conservative posture in operating plans. Capital markets are under pressure, which is impacting later stage valuations, IPO timing and potentially acquisition markets. What should venture-backed companies, in this more challenging macro environment, be focused on now?
We have found the key is to focus on what can be controlled and to be intentionally informed about what can’t be directly controlled. Madrona’s experience with our portfolio companies during the 2000-2002 and 2008-2009 eras was especially instructive. Most companies not only weathered the 2008 storm, but emerged stronger when the economy rebounded. So, let’s explore some of the key levers and what you should expect from your investors as we navigate this changing market.
What Companies Can Control
Madrona’s portfolio can be grouped into companies at three stages: (1) Discovering Product – Market Fit, (2) Building Predictable Scalability, or (3) Maximizing Long-term Outcomes. At every stage there are a set of controllable core building blocks for creating value, but the relative emphasis and stage-appropriate activities vary.
In the early years, entrepreneurs are constantly talking to customers to find product-market fit, understand the value that their product/service creates, the types of buyers who have a willingness and ability (budget or disposable income) to pay and a model to capture their share of the value they are creating. While the process of talking to customers will be a constant, it takes different forms at an early stage because of that stage and depending on the company’s type of product, purchase size, purchase frequency and opportunity to expand. It also depends on the cost of reaching those customers and moving them through the purchase funnel. Many rapid experiments are tried and those learnings are continually incorporated into the early go-to-market and product strategy.
Once a company has found initial product-market fit, it can focus on building a scalable go-to-market organization. During this phase, the emphasis shifts to understanding the key unit economics of the business. Whether the key “unit” is a city market for Rover or a selling team for Smartsheet.com, understanding the investment in dollars, time and shared resources to ramp each incremental unit is critical to rapid scale. In addition, internal business and communication processes are often stressed through this stage as a company expands from less than 100 to several hundred employees or when annual revenues grow from single-digit millions to many double-digit millions. Processes including hiring, planning, forecasting and delivery shift from direct control to “managers of managers” models. During this time, often new executives join the team with industry and scaling experience. With operational demands constantly and urgently requiring time and attention, CEO’s and functional leaders must be intentional about anticipating what is “around the corner” for the medium and long term. We refer to this process as getting to “escape velocity” and the focus becomes more on defining a market category and emerging as the category leader.
Finally, we have companies who are scaling well and are ready to focus on how they maximize shareholder value in the long term. These companies are approaching $100 million or more in revenue and have successfully addressed many of the early growing pains. They are broadly viewed as category leaders. They face challenging strategic and operational choices around product line extensions, new customer segments, strategic partnerships and geographic expansion. And, they experience a different set of break points in process, organizational leverage and, of course, the capabilities of their team to grow and succeed in their roles.
In addition to operational challenges, companies at this stage often can productively invest additional capital to take full advantage of their position as market leader. Sometimes the path to additional capital is an IPO and other times it is a late-stage growth round. Preparation for an IPO involves building operational predictability into every aspect of business as well as investment in a whole set of financial, legal and general compliance controls. Then there is the cultivation of institutional investors as well as the investment banks who primarily serve those investors. Laying the groundwork to be ready for an IPO is in the control of a management team, but it takes planning, time and dollars. And, while it forces greater operational rigor and can be a branding opportunity, the primary purpose of an IPO is to raise capital.
While all of our companies need to regularly assess their strategic advantages and disadvantages, strategic positioning is often most critical to the outcomes of later-stage companies. Companies need an accurate picture of the constantly changing strategic “chess board” in their market and an understanding of which companies could be aligned partners and may become compelling buyers over time. After all, strong M&A outcomes come when a company is bought versus sold. And, while our companies can’t directly control the strategies of their potential partners/acquirers, they can influence their thinking.
The Madrona team is primarily focused on helping our companies influence those levers that can be controlled at each respective stage. In recent weeks, we have been working with management teams to finalize 2016 operating plans with a general bias toward relatively more conservative plans. While accelerating growth takes time, it is far easier and less risky in uncertain times to “step on the gas” if you are exceeding goals then to “step on the brakes” if you are falling short.
What Companies Can’t Control but Impact Their Future
While our companies can control many things, there are three big areas where we, and our companies, have less control yet need to be informed as these factors change and influence future company direction. These areas are, in order of ability to influence, (1) the strategic landscape of their category or market, (2) the conditions in various private and public capital markets and (3) broader macro-political and economic factors.
Understanding the strategic landscape of their industry and building relationships to learn from and perhaps influence the market is a critical skill for companies as mentioned above. There are both direct players and indirect players that shape the strategic landscape of a market and companies need to be constantly aware of shifts in the market.
Understanding private and public capital markets is a bit more complex but also crucial to company decisions. These conditions inform the pricing and terms of a mezzanine debt round and the future direction of equity markets. Active investors regularly speak with investment bankers, debt providers, institutional investors, other portfolio companies and venture investors. to gain a comprehensive and current picture of the capital markets.
In addition to general market conditions, certain sectors can be hot or cold. For example, later-stage growth rounds were hot for a few years (driven principally by aggressive public investors and hedge fund pricing) and more recently have seen some tightening with write-downs and an overall pullback by those same investors. We also find that specific sectors can be in or out of favor, such as digital advertising being out of favor and enterprise cloud computing being in favor. And, of course, specific companies are more or less successful at defining their strategic positioning/story and being viewed as a hot company by capital providers. Therefore, companies can influence how they and their market sector is perceived, but are in general subject to capital market conditions.
Finally, we have no control over macro factors like geopolitical challenges (terrorism, aggression), macro-economic changes (China growth rate, global commodity prices, and currencies) and regulatory (anti-trust, trade policy, executive actions). The key strategy here is regularly monitoring the opportunities and the risks that these macro forces can present.
What you Should Expect from your Investors
What should you be asking of your investor partners – especially in less certain times? Investors should provide leverage and access. Leverage because of the information and insights they can gather across their ecosystems and portfolios. Access to people, partners and perspectives that are hard for an individual company to obtain. At Madrona, we are constantly balancing this process of gathering information and insights with the work of systematically adding value to our portfolio companies. We are surveying our industry sources to obtain every informational advantage possible. This is particularly true in the categories that cannot be directly controlled, such as the strategic market chessboards, the public and private capital markets and the global macro forces at work and. Every bit of information we can obtain assists us in making the best decisions and advising our companies.
This brings us back to your 2016 operating plan and a focus on capital efficiency. Whether companies are finding product-market fit, accelerating growth or maximizing long-term value stage, they are balancing the desire to aggressively grow with the realities of the choppy markets. They pressure test their preparedness to be more aggressive based on analyzing deeper operating metrics, core unit economics and the key forward indicators of growth. For example, at the beginning of a year or quarter, it is critical for an enterprise-focused company to understand unfactored and factored pipeline, sale rep productivity and capacity and the length, size and frequency of deal close rates.
We look forward to discussing in more detail the “things companies can and can’t control” with others and continuing to partner with exceptional entrepreneurs, their teams and our co-investment partners to build great and lasting companies.