Never Waste a Good [venture] Crisis

So, I could write about X (see this week's news) or Worldcoin. I'm in favor of both.

But this week saw a torrent of excellent writing about venture capital, particularly about the seed stage. It gave rise to this week's title - Never Waste a Good [Venture] Crisis - loosely modeled on Winston Churchill's famous utterance. These writers are being forced by circumstance to question everything, and that is a wonderfully creative time.

This week's Essay of the Week was hotly contested, but I place Correlation Ventures David Coats' essay "We're Still Not Normal" in first place.

Sam Lessin's essay about the end of seed investing, @fintechjunkie's X thread on the broken value chain in venture capital, and Packym's essay on strategy are all excellent. There are eight venture-related pieces, all substantial, thoughtful, and challenging.

We're Still Not Normal is a clever title that points to the fact that almost all returns from venture capital come from successful outliers - what is called the 'power-law.'

U.S. venture continues to be a hits-driven business. Overall industry returns, and most fund returns, are driven by the relatively small percent of outcomes that are the winners.

From the point of view of Sam Lessin, even this truth is now going to be called into question. He focuses on the "factory" model of seed-stage investing:

About 15 months ago I wrote a post on how seed investing was pretty clearly going to be in an 18 month timeout ... that the capital 'factory' line would be shutdown until the inventory of dramatically over-marked late-stage private deals got worked through / washed out / expired on the line.

This is basically how the world has looked for the last almost year-and-a-half

Now, 15 months later, he doubles down on that point of view:

The thing I think seed investors need to come to terms with at this point, is that this isn't an 18 month timeout, it is likely much much longer - and perhaps what even the death of systematic / thematic seed investing as we knew it between 2010-ish and 2022-ish...

Really, it was the Snap-Allbirds-Robinhood-Lyft-Box-Dropbox-Buzzfeed-Zoom-Oscar-BlueApron etc. Etc at deca-billion outcomes that made all the math work for seed ... and it turns out that those companies just relatively aren't work that much (some less than capital invested!)

But will clubby seed investing on a capital pipeline through series A to Z firms to public exist in the future - I actually think no... will the YC playbook of how to start a company and finance it work any more? IMHO certainly not - I think the whole factory is going to need to be shut-down and reconstituted.

"The whole factory is going to have to be shut down" is a strong statement, but it is driven by the belief that I wrote about last week - later-stage capital, and public markets, are not going to pull early-stage bets into giant-sized rapid outcomes. The entire value chain is broken. If the big checks are gone, then the growth is gone.

@fintechjunkie has a long X thread spelling out the details. After outlining the "old normal" in VC, he says:

Making matters worse, valuations were much higher during this period which brings into question how many 3X+ funds there will be in the 2017-2021 vintages. And we're already seeing markdowns and write-offs that highlight the issue.

His point is that 2017-21 investments will not produce the expected returns, so LPs will be unable to allocate to the next vintages.

Many underperforming VCs will have to reduce their fund sizes and many funds with limited track records or undifferentiated strategies will shut down. And companies will have to be built more efficiently and raise at more reasonable valuations. They'll be designed knowing that capital is scarce and scaled with capital efficiency top of mind.

Eric Newcomer's data on who is and who is not investing is full of insights. Jordan Nel of Hummingbird Ventures reinforces the analysis by focusing on the crazy idea that venture capital can be invested in like an index. He points out that the power law of returns means that a venture capital index would rely on a very small number of winners.

Firstly, the power law applies to both managers and their portfolios. Trying to index a power law without access to, or knowledge of, the top 1%, will leave you with very mediocre returns.1

Secondly, most attempts at indexing are done with what has worked in mind. But what has worked isn't usually what will work. The market is too efficient and funds swell too quickly. New LPs won't have the same asymmetry the old ones did.2

All of the articles mentioned above and linked below have solutions and remedies. I agree with some and less with others. But the drive to think, and act, is the right response to a difficult market. The only alternative is to be a victim, and there will be many of those.

Much of the narrative describing how things are is accurate. It is also why finding the outliers is crucial to venture success. Seed fund managers are the core of that process, and the best of them are very good at it. Indeed, only seed managers can solve the problem. They are the earliest spotters of future behemoths. Sam Lessin is right that YC-style factory investing will make less sense as later-stage capital is harder to find and slower to deploy at compressed valuations.

The value will still flow to the best "pickers." And they will excel at being one step ahead of innovation and finding the founders who represent what comes next.

More in this week's Video and Podcast

Essays of the Week