- In a Talkshow broadcast on April 22, Founders Fund general partner Keith Rabois discussed his predictions for the startup ecosystem with Haystack VC founder and general partner Semil Shah.
- Both are early-stage investors, but Shah told Business Insider he was interested in hearing Rabois’ opinion on the current economic crisis because Rabois had invested through previous downturns.
- Contrary to what other investors have speculated, Rabois said that all startups are at risk of financial struggles during the downturn, and those with fundamentally sound business models could be most at risk because they have the most to lose.
- Rabois said that there were already several weak spots in the startup ecosystem prior to the crisis that were close to boiling over, like high overhead costs and reliance on growth over profitability.
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The looming cash crunch is coming to startups. Yes, even the subscription-based enterprise startups many investors have claimed are immune to such concerns.
That’s Keith Rabois’ theory, at least. In a Talkshow conversation with Haystack VC founder and general partner Semil Shah on April 22, the Founders Fund general partner and well-known contrarian walked listeners through his predictions for the startup ecosystem in the looming downturn. It wasn’t exactly the rosy outlook many other investors have clung to.
The startups that are particularly at risk, according to Rabois, are those that rely on healthy margins for per-unit sales. For example, an enterprise business that has relatively low fixed costs but is able to charge its customers on a per-person basis to use its software qualifies as one with a healthy contribution margin. These companies, one of which Rabois identifies as Airbnb, haven’t had to operate as efficiently as they could, and are less prepared to acclimate swiftly.
“The stellar companies that have been highflyers are going to suffer,” Rabois said. “Not all of them will, like the DoorDashes of the world are growing faster in today’s world than before, but more high-profile companies will have at least blips, if not fundamental issues to confront.”
In the past, investors have gravitated towards businesses that have the high margins. But now, those metrics might seem to be a less perfect measure of the health of the business, according to Rabois.
These types of businesses are typically considered reliable revenue earners, and they become successful long-term investments if they continue to operate in that way. But according to Rabois, many startups that would otherwise have those margins have chipped away at them with the enormous fixed costs associated with operating in Silicon Valley. Between headcount, real estate, and marketing expenses, the margins have been trending downward for the last decade.
“Most of these issues were simmering below the radar for at least the last year,” Rabois said. “There’s a correction going on underneath the hood in many of these companies completely independent of a virus. The virus just put a spotlight on it and to some extent convinced some nonbelievers.”
The biggest offender was the reliance on growth, or the appearance of growth, over fundamentally sound unit economics, Rabois said. That led to a valuation inflation, which is starting to track back down to historical levels.
However, not all the troubles that companies will face are due to those latent fault lines in the startup ecosystem, Rabois said. For some, the pandemic can be seen as a root cause.
“There are a few companies where, oh my god the business was amazing before the virus, and the effect of government policy and the virus may have created a fundamental shift in even temporary or permanent attractiveness of the business,” Rabois said.
That’s the kind of perspective Shah said he was hoping to get from Rabois during the live discussion, due to his relative prominence and permanence in the startup ecosystem. Shah told Business Insider that, as an early-stage investor, he was personally interested in, and figured others would want to learn from, an industry veteran like Rabois.
“A lot of people like me, we sort of know what happened in the Great Financial Crisis or dot-com bust, but we didn’t live it,” Shah told Business Insider. “We need to hear the stories and perspectives of the people who did live it, because it seems like a completely different kettle of fish.”
SEE ALSO: Experience could be the make-or-break factor for VCs hoping to thrive during the downturn, but a new study finds just 23% of existing firms are up to the challenge
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