Reversion to the mean: the real long COVID

Private financings could soften significantly…what would you do if fundraising on attractive terms proves difficult in 2020 and 2021?

With softening sales, you might find that your customer lifetime values have declined, in turn suggesting the need to rein in customer acquisition spending to maintain consistent returns on marketing spending.

2020-2021: tech exponentialism

1. Falling interest rates: Rates dropped to near-zero, making a dollar of profit in 2030 nearly as appealing as a dollar in 2021. Companies with profits far in the future – think high-growth and high-risk companies – got undue credit for those future dollars.
2. Rising tech demand: COVID raised the demand floor for online alternatives to physical businesses. E-commerce doubled. Food delivery tripled. Video conferencing quintupled. This created a credible argument for tech domination: DoorDash would crush restaurants, Zoom would render offices obsolete, Peloton would eliminate gyms.

• Exponential: Pandemic era acceleration represented the new baseline growth rate. Instead of growing 10% annually, e-commerce and other categories would have a new sustained level of high growth.
• Step function: COVID established a “new normal” for tech demand, a step function above pre-pandemic levels. Old growth rates would continue post-COVID, just from a higher base established in 2020. This was a popular view among VCs and tech pundits.
• Mean-reversion: Acceleration through 2020 and 2021 was an aberration, and tech market growth will revert to the pre-COVID growth trendline.

2022: tech reverts to the mean

The mid-2020s: stagflation is a lingering symptom

• Labor cost: Rising salary expectations are the most obvious and direct impact to startups. When inflation became common knowledge in the 1980s, unions pre-negotiated annual wage increases – this could happen in tech. When salaries rise, you have to burn more capital to build the same products. While labor cost inflation will slowly restabilize, expect regular wage hikes for the next several years.
• Productivity: In a more competitive tech talent market, employees expect not just higher compensation, but less work – a double whammy. The four-day work week is already gaining popularity. And many employers are acquiescing for fear of attrition.
• Equity burn: This is a painful inflationary backdrop to every startup, and under-appreciated even at the most sophisticated companies. The option pool is each startup’s internal Federal Reserve, setting an “inflation rate” for your share price. As competition for talent increases, so does your option pool inflation rate. Every year, your share price is offset by option pool expansion, which can range from 2-5% for growth-stage companies. Public companies are offenders too, with stock-based compensation constituting 10%+ of revenue for many tech companies.
• DCF impact: If your cash flows are far in the future (high-growth and sub-scale businesses), USD inflation and rising rates hurt you the most. As interest rates rise to match inflation, your valuation gets less credit for profit generated in ten years from now. If your average dollar of profit comes in thirty years from now, your stock would be down ⅔ from mid-2020 even if nothing changed about the odds of that dollar being earned.

How should we navigate tech stagflation?

Investors

• Wish list: In 2021, every software company with a pulse warranted a 100x valuation multiple. This meant mediocre companies were massively overvalued. But the inverse is also true: in a market reset, multiple correction means that the best companies will go on sale, too. Come up with a target list of your top 10 picks so you’re ready if and when companies reach renormalized prices.
• Counter-cyclicality: Investors always tell their LPs that they invest in secular shifts – they’re currently figuring out how secular some of those shifts really are. But an even better strategy may be to find counter-cyclical categories: energy, healthcare, infrastructure, and defense are contenders for truly macro-proof industries.
• Consolidation: We’re likely to see strategic M&A and rollups, particularly in mid-stage software startups that don't achieve escape velocity. Companies that cannot grow fast enough to justify high burn will need to find acquirers as private funding markets soften.
• Remote work: Hybrid and fully remote work is far more permanent than people expected. Remember that in March 2020, people expected a return to the office within a couple of weeks. The return date slipped for weeks, then months, and in many cases, indefinitely. Today, hybrid work is commonplace for white collar workers at large companies, and many startups are building products to support the shift.
• Crypto caution: Crypto and web3 exploded during COVID. Non-BTC crypto is up over 10x since 2020. Billions flowed into projects promising fast profits. Enthusiasts argue crypto disruption of traditional financial institutions is imminent, but the 2021 run-up seemed more driven by a collective belief in the ROI of lottery tickets – a symptom of easy money. Is web3 overvalued?
• Institutional mistrust: Distrust of centralized institutions – government, big tech, schools – skyrocketed following pandemic-era authoritarianism. These second-order tailwinds could linger for years, opening up opportunities for startups building the future of privacy, transparency, decentralization, and education.

Founders

• Agile spend: Some spend, like online ads, is easy to control: if you want to cut your ad spend in half, you can do so immediately. But some costs are hard to unwind: Peloton massively ramping up hardware spend assumed a sustained demand level that was in fact temporary. Hiring to meet demand spikes is tricky, too: see Hopin’s recent layoffs as a cautionary tale. Avoid fixed costs for variable demand, and be ready to unwind them quickly if demand softens.
• Fundraising expectations: VCs have been underwriting your business based on high-growth public comps, so look to public companies’ valuations and strategies as guidance for how to benchmark your business and build out your investor narrative. Getting fundraising tips from founders who raised in 2021 is irrelevant – it is far more useful to ask founders who raised pre-pandemic.
• Isolate pandemic and secular demand: An exercise in finance and data science, the best teams will isolate temporary and permanent shifts in business fundamentals – CAC, retention, LTVs. Assessing these variables requires ruthless intellectual honesty. Gauging retention means filtering through customers with a recent renewal option: are customers purchasing and engaging with your product at the same rates post-COVID?
• Geography: The pandemic shed light on San Francisco’s many problems. The positive network effects of Silicon Valley are increasingly offset by negative network effects – homelessness, taxes, political groupthink. But physical offices drive productivity and culture, while free-rein remote work lowers employee accountability and learning by osmosis. Is returning to the office undervalued?
• Profitability: The best time to learn how to build a finance model was when you raised outside capital. The second best time is now. Having visibility over your business levers is table stakes. A concerning number of companies raised on a simple deck or memo in 2021 – if you have never been through a challenging fundraise, you could be in a world of pain if you don’t control your financial destiny. Profit is the great equalizer.

Employees

• Scrutinize businesses: When evaluating prospective employers, candidates often substitute valuation for job security. If you’re assessing a company that last raised in 2021, don’t take solace in the billion dollar valuation they fetched. Understand their actual revenue scale and financial health (margins, runway, growth rate) to get a sense for the magnitude of the business. Great businesses will survive, but it could take years for the fundamentals to catch up to 2021 entry prices. If you’re uncertain on how to value various companies yourself, speaking with tech investors is a reasonable substitute.
• Assess product durability: When looking at job opportunities, be discerning on the durability of the product value proposition. If they experienced exponential growth during the pandemic, will it continue after trends revert to the mean? This should be fairly obvious at a category level: mission-critical infrastructure software is likely durable; a levered bet on virtual events may not be.
• Find recent data points: Put increased weight on current data points from startups. Recent fundraises and signs of product-market fit carry additional merit – bonus points for indicators from the past one or two months. Of course, joining seed-stage companies is a completely different risk profile, which is relatively macro-agnostic.

Conclusion

• Political unrest: From the BLM protests to the January 6 Capitol riots, protests spiked across the political spectrum during the pandemic. The reduction of face-to-face human interaction made humans far more volatile. With more human contact and less idle time, politics may stabilize going forward.
• Retail trading: Retail trading volumes reached a new baseline in the pandemic – volatility, boredom, and stimulus checks are a powerful cocktail. GameStop and Dogecoin represented peak retail trading. Volumes have already started to renormalize.
• Authoritarianism: From country-wide lockdowns to permanent Twitter bans, authoritarianism popularized during COVID. Thankfully, freedom antibodies have started to form: SF residents recalled the school board to focus on returning kids to school, the Twitter algorithm could become ban-resistant and open source, and the mask mandates have been struck down.
• Consumer habits: Travel halted, movie theaters shuttered, retail spending and GDP plummeted in 2020. The speed of return has been uneven across categories, but travel is nearing pre-pandemic levels, GDP has reverted to the trendline, and movie tickets are on the rebound. I wouldn’t invest in a movie theater chain in 2022, but the death of the old economy is further out than the 2020 forecast suggested.