Originally published on Substack — January 10th, 2022
What Pain Tastes Like
Anyone who is invested in public tech stocks has been feeling a lot of pain over the last few weeks. High growth software has seen a ~50%+ correction and the businesses with the highest multiples have seen their median forward revenue multiple drop from 80x a few months ago to ~34x. Internet multiples are in a similar place within the same time frame.
Crypto hasn't felt much better with Bitcoin down 14% in the last month, dropping below $40,000 for the first time since August and Ethereum down 23%. You see people losing $40K a month and perusing the job offers at McDonalds.
None of this means SaaS is dead or crypto is trash. I’m not calling a market top or a financial crisis by any means (though I agree with some people that its unlikely multiples completely rebound to recent ATH.)
But hopefully this is a wake up call for a lot of people that haven't experienced nearly enough of them. And maybe I'm just filled with existential self-loathing but I'm early enough in my career that I'm not afraid of suffering. I’d go as far as to say I welcome it.
In 2000 I was just getting started in little league and in 2008 I knew more about the cast of Iron Man and The Dark Knight than I did about the housing market or any kind of securities.
Like a lot of investors today, be they the professional, YOLO, FinTwit, or TikTok variety, I haven't seen a significant financial correction in my career. Though that doesn't stop me from sitting on my porch, smoking a pipe, and telling my children stories of the March 2020 bear market.
I don't want anyone to lose their life savings but I welcome a game that is more difficult to win. I believe it was Warren Buffett whose TikTok account popularized the strategy of "when the stock goes up, buy the stock." Don’t get me wrong, the democratization of investing is one of the most exciting trends I've seen recently. But a market that never goes down hides a multitude of sins. I want everyone to be an investor, but I don’t want everyone to be an investor who is convinced they’re a genius.
Speaking of games that feel harder to win, Krishna Gupta started a venture fund in 2008 in the middle of the financial crisis:
"The only people starting companies in that kind of bust period are really serious about it. So the talent becomes more clustered. For instance, if you have four people who are really good at what they do in a 2008-type period, they come together to start one or two companies. Today, they’d each start their own companies. So you now have much more fragmentation of talent, you have more competition, and you have much higher valuations. That’s a triple whammy that doesn’t really help you out as an investor. I actually really liked 2008 — I felt that the conversations I had and the types of entrepreneurs I met were just much more audacious and authentic."
Some pretty generational businesses were started in the few years just after the financial crisis. There is some selective bias where you can probably find some great businesses started in almost any year. But you see stories of unique grit born out of the companies started during a pretty painful period.
Since 2008 we've had what feels like a never-ending dream. A lot of investors have made a lot of money. But the world is changing. It's getting quicker. More expensive. More complex. More commoditized. You're going to see a revolution of investing, both in terms of people and processes.
Here Comes The Punch
"Everybody has a plan until they get punched in the mouth." (Mike Tyson)
As I start the new year bracing myself for a world of pain I've started thinking about what I want to better understand. The first step in getting ready to learn from pain is acknowledging the possibility that you might be wrong. Charlie Munger talks about Pain-Avoiding Psychological Denial where "reality is too painful to bear, so one distorts the facts until they become bearable."
Reality is likely to come crashing down on us here and there over the next few years and I'd like to shore up my mental resilience. These are a few things I'd like to write about over the course of the year:
Returns From Here
It has almost always been true that the very best businesses have a premium valuation (sometimes only slightly so). But when you start to value every company as if it will be one of the 5 best companies ever you'll be disappointed more often than not. Not every company will be Salesforce.
The other piece that comes with inflated valuations is the fact that "good, not great" outcomes largely get taken off the table. If you're a $1B company with a few million of revenue you've effectively removed the optionality for a sub-$1B acquisition. Maybe there is a "burning the boats" mentality there but for a lot of people those smaller acquisitions have been just as life changing and can pump solid liquidity into the broader market. More wealth, more angel investors, more companies.
Bill Gurley was calling a market top in 2016 when he talked about 2015 multiples contracting from 10x revenue to 4-7x (talk about your grandma’s public markets) and saying "never in the history of venture capital have early stage startups had access to so much capital." In 2016 $63B of VC money went to startups vs. $600B+ in 2021.
The music has clearly continued to play since then, and even Gurley himself says "the best way to protect yourself from the downside is to enjoy every last bit of the upside." But for a lot of companies, the music will eventually stop or at the very least slow down. No founder that I've seen has laid that out more honestly than Nick Mehta at Gainsight. When I started my career as a venture investor Gainsight was a hot company that a lot of people talked about. Nick talks all about that feeling of having tons of investors reaching out. But then their growth slowed. They hit a wall. Net new ARR became more scarce. They reached the limits of their TAM. And they slugged it out for 4+ years without raising a meaningful round before they were finally acquired by Vista for $1.1B with $100M+ of revenue.
"[Fundraising] can feel like a no-win situation. If you don’t raise money at these incredible valuations, you might pass up a chance to take your company to the next level. If you do raise money but end up hitting a growth wall, you could end up stuck. The answer, upon reflection, is clear. Take the money. But be prepared to game plan for lots of potential scenarios in the quarters ahead." (Nick Mehta)
Like my Mom always says: "Plan for the worst, and hope for the best."
Question to consider: What do inflated valuations mean for returns to investors? To employees? To founders? How do you balance getting the highest quality investors without setting yourself up to fail?
For the last few years we've seen a continued tightening in the labor market in tech. 57% of execs say labor shortages are their number one concern. More recently, in the latest correction some employees have seen their equity lose 30-80% of their value. Joining a startup as employee 50 may be a lot less life-changing than it used to be because those companies are now typically valued at ~$1B+.
Harry Stebbings had a tweet about talent (that he might have deleted, cause I couldn't find it). Effectively his point was that there is a natural selection among startups. Not every company will survive and it can be a healthy recycling of talent back into other companies. In a world of abundant capital fewer companies are dying, which means talent doesn't recycle as often.
David Ambrose made a different point about talent where nose-bleed valuations for unproven companies can make it "really challenging to attract strong talent who believe their equity can grow in multiples...[for] something that they believe is irrationally valued."
Lots of good companies need lots of good engineers. It's worth considering what will happen to that labor market in the face of a massive valuation correction.
Question to consider: How should employees be evaluating their options in terms of where they can experience the most upside? And why are most companies grossly over-estimating the value of the options they’re offering employees?
Importance of Post-Mortems
In a market where very little has gone wrong there isn't always as strong a pull to reflect. No one ever found themselves staring into the abyss wondering what went wrong after they just 5x’ed in one year. When looking backwards everyone sees their decisions as a well-measured journey driven by unique insights. Any investor would benefit from an additional dash of accountability.
"Keeping a journal of your own performance is the easiest and most private way to give self-feedback. Journals allow you to step out of your automatic thinking and ask yourself: What went wrong? How could I do better? Monitoring your own performance allows you to see patterns that you simply couldn’t see before. This type of analysis is painful for the ego, which is also why it helps build a circle of competence. You can’t improve if you don’t know what you’re doing wrong." (Shane Parish)
Questions to consider: What is the best format for running a post-mortem? At what point do you have enough information to effectively evaluate the positives and negatives for any given decision?
Developing a Spirit of Humility
I think often about the "spirit of humility" that investing requires. The unrequited confidence that I see from a lot of investors is like watching a ticking time bomb. A herd of people approach investing believing so confidently in themselves, often because "being wrong (and excited) is less painful than being right (but boring)."
The real trick is being humble enough to have conviction while never putting yourself in a position to get wiped out. Morgan Housel says it like this: "The ability to stick around for a long time, without wiping out or being forced to give up, is what makes the biggest difference."
The internal monologue running in every investors head is painting them as the hero contrarian laying out what they believe but that everyone else is wrong about. There is an epidemic shortage of people willing to ask the question "what am I wrong about?"
Questions to consider: How do you balance high conviction bets with unqualified humility?
Taking a Long-Term View
So many people are quick to say they’re long-term investors but count the hands of people willing to take a long-term view when they’re staring down the barrel of a 20% loss. One of the things I’ve thought the most about has been the two-sided stick of investing in a winner. I hate the “if you’d invested $10K at IPO…” thirst traps, but when you pick up a winner with massive gains you typically have to pick up the other end of the stick; massive losses.
Being willing to take those losses psychologically is a critical piece of capably taking a long-term view. That’s a psychological resilience that I want to better develop.
Questions to consider: What does it take to have conviction in the face of massive losses? How do you balance conviction and resilience with a willingness to reevaluate your views in the “spirit of humility?”