Don’t Fight the Downturn in Valuations, Use It
The global selloff is depressingly depressing for investors. At that same time, it also offers a wide swath of opportunities in public and private markets. As you work to find bargains, venture capital is one area not to miss over the next couple of years. As public markets have repriced risk and growth, the venture capital market is lagging behind this trend and it may take a while before valuations completely reset. Nevertheless, capital is scarcer today. And if you have capital you are in a much better situation than in the last 10–15 years, when literally everyone was looking to invest.
In the last several years, venture capital has been characterized by an abundance of capital scratching to get into a number of “hot” deals. Most of these transactions were based on low-interest rates and escalating multiples. Frequently, the strategy was to invest in high-margin, high-growth businesses (like B2B SaaS businesses) that can be sold or IPO’d based on increasing cash flow. When positive fundamental trends were coupled with increasing cash flow multiples on such businesses, it effectively added gas to a massive blaze. This is now changing. Interest rates have risen and multiples are just as likely to contract as to increase with time. Moreover, not every B2B SaaS will succeed. As a result, VC valuations are changing. Rapidly.
Despite this set of facts, a downturn is a perfect time to find unique startups that will change the world going forward. Even with an uncertain macro backdrop, there are still many problems (maybe even more?) that startups can solve. Solving a problem equals a valuable business if done correctly.
One approach to access these investments is to join a venture capital syndicate. A syndicate is a group of investors that pools their capital to invest in deals. Most often, this is accomplished through the creation of a special purpose vehicle (SPV) to invest directly into a startup. The benefit is that you get access to deals that you might be unlikely to find on your own.
Here’s an example: Helene, a venture capital investor, decides to lead a syndicate to invest in startups. She finds a startup that shows real promise and decides that she’d like to invest in the company. Her syndicate is comprised of 200 other investors. Collectively, they decide to invest $200k ($1k per investor) in the new startup. Helene decides she would like to invest $25k of her own money into the startup. An SPV is created and through this SPV, $225k is invested in the new startup. Actually, after fees less than $225K is invested.
If the startup succeeds, the syndicate investors first receive their $200k, after which every dollar of the syndicate profit is split 80% to the syndicate investors and 20% to Helene (in this example Helene’s carry is 20% but carried interest can vary from deal to deal). As you can see, this endeavor could be quite profitable for Helene. However, if the company does not ultimately succeed, then Helene receives nothing and neither do the investors.
We follow this formula ourselves. We use AngelList to help with the setup and administration of the Flourish Fund syndicate. As a result, AngelList charges a setup fee for this work. In addition, if they brought in some of the investors, then a subsidiary of AngelList may also share in the carried interest (the 20% described above) with us.
The beauty of the syndicate structure is that there is no upfront capital commitment to see deals. Our group members don’t have to invest in any of our deals. Plus, there is no cost to be a member (or “back” our syndicate as AngelList says). Joining the syndicate simply allows potential investors to see our deal flow. By pooling funds with other investors, the syndicate structure allows investors to get a higher number of investments, increasing their odds of a deal performing well by having a more diversified portfolio.
With this option, investors can construct a diverse portfolio that provides them with some unique exposure to companies formed during this market contraction. Fortunes are made in the downturns. While profiting from a potential stock market recovery can be quite rewarding, cast your vision wide. Don’t ignore startups and the reset in valuations.
