Economic Contraction

Forbes Midas List VC Hints Funding Winter Could End By 2025

Our type of capitalism is terribly inefficient. Between 2010 and 2021, she threw too much money into too few good investments. This drove stocks up at a rapid rate – and it was generally nice to own them during this time.

Unfortunately, there is no bell that rings to tell you that it is time to take your profits. Looking back, I regret not seeing last November’s decision to reappoint Jerome Powell as Fed chair as a definitive sell signal.

Why is this important? As I wrote in April, the decision on Powell meant that the White House had concluded that inflation was not temporary, as claimed by Janet Yellen, and would only be cured with rates higher interest rates – which repels equity investors.

Since then, capitalism has taken money sharply out of public and private equities – wiping out trillions of dollars of stock market wealth and denting the valuations of private companies backed by venture capital.

Why does capitalism demand these extreme swings between fear of missing out (FOMO) and fear of missing out? What should investors and CEOs do about it?

For answers to these questions, I turned to Gordon Ritter, founder and general partner of Emergence Capital Partners, which made Forbes’ Midas List four times. Here are the highlights of my June 23 interview with Ritter:

  • Beware of FOMO-driven companies that are trying so hard to achieve near-term triple-digit revenue growth that they overlook key new product areas
  • Follow the example of companies resisting the siren song of FOMO and leading the creation of customer value
  • When FOMO stops and venture capital markets freeze, CEOs should kill pet projects and focus on how they can satisfy customers
  • To diversify revenue, startups must shift from selling to other startups to targeting established startups
  • During the recession, CEOs should invest in a sales team capable of convincing “rational buyers”
  • Ironically, during a venture capital freeze, risk taking increases and truly innovative ideas are funded. For example, Emergence Capital has invested in coaching networks — AI-powered services that identify and disseminate best practices in sales and other types of jobs.
  • During the dot-com bust and financial crisis of 2008, it took two to three years for investors to bottom out and start investing for growth. If this trend continues, I estimate that venture capital investments will pick up again by 2025

Portfolio companies selected by Emergence Capital

Emergence Capital has invested in many BTB companies, starting in 2002 with SalesForce.com. While most of the following emerging companies have had incredible runs after their IPOs, they are now trading below their highs.

  • Selling power. Shares up 42,910% since going public in 2004; on June 23, SalesForce was trading 40% below its November 2021 high while its latest quarterly revenue rose 24%.
  • Veeva Systems. +355% since its IPO in 2013; on June 23, Veeva was trading 42% below its high of around $344 in August 2021, with its latest quarterly revenue up 16.5%
  • Enlarge the video. +90% since its IPO in 2019; on June 23, Zoom was trading 79% below its October 2020 high of $559 with its latest quarterly revenue up 12% (below 355% growth in the second quarter of 2020%) .
  • Box. +6% since its IPO in 2015; on June 23, Box was trading 24% below its April 2022 high of around $33 with its latest quarterly revenue up around 18%.
  • Bill.com. +220% since its IPO in 2019; on June 23, Bill.com was trading 64% below its peak of around $349 in November 2021, as its revenue for the last quarter of 2022 increased by 179%.

Why Customer Value-Driven Companies Beat FOMO-Driven Companies

When a FOMO bubble develops, investors cannot get their capital out of startups fast enough. While many of these startups may fail, investors fear not being in the game more than losing their money.

Once they have a stake in the game, they push startup CEOs to achieve rapid growth so they can go public before the IPO window closes. As the FOMO bubble grows, Ritter told me, “If a company goes from 1 to 3 or 4 in six-month increments and doesn’t care about taking risks, creating new products, [or finding a path to profitability]; he can get 100 times the annual ratings of recurring income and increase his A, B and C rounds in one year.

When the FOMO bubble bursts, these companies risk being driven out. To avoid this fate, Emergent encourages its portfolio companies to resist FOMO. Ritter admires companies that are slow to push the pedal until they have created products that customers will appreciate more than competitors.

Zoom Video followed this approach. As Ritter put it, “As Eric Yuan, Founder and CEO of Zoom, mentioned at our May 2022 CEO Summit, ‘Everyone told me I was crazy. didn’t need a new video conferencing solution. An investor said he’d write me a check for something more than that. [Yuan] took about two years from 2009 to 2011/12 to rebuild Zoom’s code because they wanted to deliver the best product in the industry.

Ritter also offered advice for VCs on how they can resist FOMO and find founders who will do the same. “General partners should resist the urge to raise additional funds from limited partners who may ask them for more capital during a boom. Resist [bad investments] new partners trying to make a name for themselves. Don’t bet on founders who show pride. Favor those who focus on the viability of their business, who build a moat and who align the economics of their unit,” he explained.

How businesses should operate during the capital’s winter

When capital providers suddenly become reluctant to invest, startups must adapt to the changing competitive environment. For example, Ritter suggested that companies should

  • Scale up. Startups should diversify their customer base, from venture-backed startups — which may be forced to scale back purchases — to established businesses. Ritter pointed out that Y-Combinator-backed startups are encouraged to buy other people’s products to drive their rapid growth. When a venture capital freeze hits the industry, these revenue streams can be threatened. Although selling to established companies may take longer, they are more likely to continue buying during a venture capital freeze.
  • Focus on product development. Startups should reduce their investments in minor changes to current products and develop bold new products that customers will find most valuable; and
  • Strengthen the sales force to attract rational buyers. As Ritter said, during the FOMO part of the business cycle, enterprise customers are encouraged to use the software they love. When the bubble bursts, companies try to cut costs and make operations more efficient by cutting back on the most essential software tools. To that end, leaders need to build their sales forces to convince chief technical officers (CTOs) that their startup’s product will be among the top three to five that the CTO decides to stick with.

Are coaching networks the next big thing?

Times of economic contraction are often when entrepreneurs decide to take a risk by launching the most ambitious new products. As I wrote in April 2021, that’s what Todd McKinnon did in the depths of the 2008 financial crisis when he left SalesForce to launch Okta, the cloud-based identity management service.

For several years, Emergence has been working on Coaching Networks — which it believes could be the next big thing. Ritter described these networks as “machine learning meets forms-based software.”

For example, he said Emergence has invested in Textio, which teaches writers how they can increase the chances of getting a positive response from people who read their work. Another Coaching Network investment, Guru, connects workers to best practices found in institutional knowledge to accomplish specific tasks.

When will venture capital investment increase again?

In past recessions, it has taken two to three years to overcome partnership disputes that typically prevent venture capitalists from making big investments. During these times, it is much more difficult for startups to raise capital and grow.

It may be until 2025 before venture capitalists want to focus on growth opportunities. In the meantime, Ritter has not shared his views on what SalesForce, Zoom, Veeva and Box will do to accelerate their growth and restore their lost market capitalization.

If soon-to-be-released economic statistics indicate that GDP has contracted and inflation is moderating – as oil company stock prices have fallen (for example, Exxon shares are trading 18% in below their June 8 high) – investors may conclude that the Fed’s aggressive interest rate hikes will begin to subside.

That could mean more trading days — like June 24 — where tech stocks rise faster than others.

The sooner tech stocks bottom and start rising, the sooner VCs will anticipate a rally in the IPO market, which will make them more eager to invest more capital in fast-growing startups.