Maintaining Optimism in a Downturn


Stable Coin Scandal, Public Market Drawdowns & Recession Resilience

A recession is defined as an economic decline represented by two consecutive quarters of negative GDP growth. So according to the textbook definition, we are entering the early phases of one. This will be no surprise to many of our readers. As it circulates through the news cycle, there appear to be three major themes influencing public perception of the downturn and the speed with which we may be able to dig ourselves out of it.

  1. The precipitous crash of algorithmic Stable Coin TerraUSD (UST)
  2. Bearish sentiment on public tech stocks & private market contractions
  3. Dry powder eyeing the next phoenix to rise from the ashes

The not so stable Coin

On paper, the crypto universe may appear disconnected from traditional finance. But as the nascent DeFi movement edges its way further into the mainstream, soft tissue connections between trading tokens and “real world” stocks are building. You’re likely familiar with Bitcoin (digital gold) and Ethereum (the blue chip of all smart contract-based digital currencies), but if you head over to any crypto index, you’ll find hundreds (if not thousands) of available tokens to acquire. Among them are what have been dubbed “stable coins” — an effort to produce a token that maintains a relatively, well, stable value. This is a direct response to the price volatility (and impracticality) of the market swings affecting Bitcoin, for example. Making purchases with most crypto currencies is like buying a loaf of bread in 1923 Weimar Republic: highly unpredictable. So in theory, pegging a coin to a (relatively) stable currency like the US Dollar is a good thing. UST isn’t the first crypto-project to attempt this; in fact, there have been a few approaches (as outlined in the chart below).

Source: a16z State of Crypto Report

Fiat backed stablecoins mimic the gold standard in traditional currencies: hold enough reserves to justify the price. In this case, the reserves are denominated in USD — therefore, it’s stable, capital-efficient but not very decentralized (a core principle behind DeFi). Crypto Backed stable coins operate much the same way, but are on chain, holding reserves of other established crypto currencies in smart contracts to maintain a constant price. The newest incarnation is the algorithmic stablecoin. Here’s a brief explanation on how it works from Fintech Business Weekly:

“It’s worth noting that Terra took a relatively novel approach to constructing its stablecoin. While collateralized stablecoins like USDC or Tether purportedly hold dollars or dollar-denominated assets backing the stablecoins they issue, Terra did not (until recently, when it began purchasing large quantities of bitcoin as an emergency backstop.)

Instead, Terra’s “algorithmic” stablecoin relied on an ecosystem of multiple, interlinked tokens, incentives, and arbitrageurs to balance supply and demand of TerraUSD such that it maintained its peg to the US dollar. If you want to dive into the details, Matt Levine explains the conceptual framework quite clearly here and a recent episode of the Odd Lots podcast discusses relevant related topics, like DeFi yield farming.”

The algorithmic approach relies heavily on an ecosystem of users as well as the belief in the value of the coin. The article linked in the above quote alluded to it as a “ponzi scheme waiting to collapse under its own weight.” This is not the first stable coin to enter a “death spiral” as noted in Fast Company, yet it remains to be seen if it will be the last. In the meantime, news of the Terra (UST) crash has rippled through the ecosystem, sending the broader market into freefall. Bitcoin hit an annual low and another USD-pegged stable coin, Tether, fell to .95.

Source: Coin Market Cap

So what does it all mean? As a savvy investor, regardless of the market you operate in, it can be valuable to reflect on the macro trends across ecosystems. In this case, you might be inclined to say this is yet another validation of the bear case for crypto. However, if you overlay frameworks from other downturn experiences, this could very well be a culling of the herd moment: tough lessons learned, survival of the fittest, and only the top performing projects will emerge as viable, long-term cryptocurrencies. If you are holding crypto in your portfolio, perhaps take a look at this insightful thread from Michelle Baihle at Sequoia (or maybe this one for the more crypto-inclined). If not, this could be an asymmetric opportunity to evaluate what comes next and get on board. Afterall, this space mimics the market cycles of traditional tech, the only difference: it’s growing even faster.

Source: a16z State of Crypto Report

Multiple Contractions, Divided Markets

A combination of macroeconomic tailwinds including inflation, supply chain issues, interest rates, labor shortages and the looming recession have led to a major correction in tech stock pricing from pandemic highs. The decade-long bull run in the tech sector was largely supported by an investor base seeking massive scale at the expense of profitability. The pandemic exacerbated the winner-take-all dynamics of key product categories poised for a remote-first world. The recent change of heart reflected in the stock market implies a demand for security, business fundamentals and above all else: EBITDA.

Multiples for the Top 10 Software Companies cut over half (Source: Clouded Judgment Newsletter by Jamin Ball)

Some analysts have likened the current situation to the early 2000s Dot-Com bubble, others the 2008 housing crisis. But many argue that this feels altogether different. Many startups have had to tighten their purse strings, reduce burn rate, and in some cases layoff a fair percentage of their staff (see: OnDeck). In an internal memo to Uber staff, CEO Dara Khosrowshahi wrote “The average employee at Uber is barely over 30, which means you’ve spent your career in a long and unprecedented bull run. This next period will be different,” which is pretty remarkable if you think about it (see full memo here).

In times like this, it becomes a matter of survival. One of the best data-driven approaches I’ve come across is called the Burn Multiple, a concept put forth by David Sacks of Craft Ventures. The equation is as follows: Burn Multiple = Net Burn / Net New ARR. This emphasizes cash burn not as a function of reserves (i.e. funding) but rather as a function of net new ARR. In order to survive, you need runway, if you can cancel out burn with ARR, you’ve in effect spared your capital reserves and extended the amount of time you have before you’re out of cash.

Source: Bottom Up by David Sacks

Despite the belt-tightening and short term losses, history would indicate that an economic downturn is possibly the best time to build.

Source: “Innovation in a Crisis” via McKinsey & Co.

Necessity is the Mother of Invention

Like a controlled forest fire, a recession clears the brush, creates opportunity for new growth and may help prevent an even bigger disaster down the line. Bloated staff, untidy balance sheets and exorbitant spending get realigned with base reality. Simultaneously, those who rise to the occasion — both sluggish corporations becoming nimble and new market entrants solving a problem no longer prioritized by existing players — will make it through the downturn and develop resilience to accelerate their growth in boom times. This presents one challenge for startup founders and a completely different one for investors. As it turns out, dry powder in VC is at an all-time high thanks to unprecedented fundraising in the past several years.

Source: John Sakoda of Decibel VC on Twitter

Nevertheless, a few questions come to mind:

  • Will this dry powder get deployed and how?
  • Does the alchemy of investing change significantly now that we’ve entered a recession?
  • Will investors stick with their convictions and maintain their thesis?
  • How do we identify the strongest, most resilient and recession-proof businesses?

“A Crisis is a terrible thing to waste.”
– Paul Romer, Economics Professor, NYC

Here again, it makes sense to crack open the history books. There are several household names that were born during an economic downturn. Recent ones include:

  • Airbnb
  • Uber
  • Coinbase
  • Slack
  • Zoom
  • AngelList
  • Square
  • Venmo
  • Instagram
  • WhatsApp

So what did these companies do well? How did they adapt their strategy to the economic realities of the moment? What principles did they put in place to ensure success? My favorite example among the list is Airbnb, a company that has gone through an extraordinary journey from long-shot idealism to publicly listed company. Not only is Airbnb recession-proof but pandemic-proof: seemingly impossible for a global travel business!

Source: Dan Croitor on Youtube

Co-Founder and CEO, Brian Chesky, has spoken on numerous occasions about the process of building Airbnb: from couch surfing to knocking on host doors to take pictures to becoming more than a travel company, but one of community. Despite global recognition today, their humble beginnings were challenging to say the least. So it didn’t help that they were building during a recession. Ultimately, however, a recession serves as a forcing mechanism. Tradeoffs become reality, compromise is necessity, communication is critical and tough decisions are inevitable. In boom times, you can sidestep these confrontations (or at least postpone them), which atrophies the corporate muscle necessary to maintain discipline and achieve targets.

Vision, mission, value system, principles — these are all terms startups use to help define their goals, above and beyond the product they offer. No one joins a team to build an API or a booking site. But an opportunity to build an app that will make everyone feel they belong is pretty compelling. As always, it’s easier said than done. Creating your core principles is only the first step; living by them during good times and bad is another. Airbnb has dealt with plenty of adversity, including the postponement of their much awaited public offering (delayed due to Covid-19). But I believe they serve as one of the premier examples of a company that embodies resilience, humility, generosity (see their effort to host Ukrainian refugees) and purpose. I highly recommend watching this clip of Brian Chesky outlining each of the 6 principles across various interviews over the years.

Source: Pitchbook (sample of 18K deals, globally)

We’re now equipped with plenty of dry powder and a framework for resilient businesses. What next? So far, according to Pitchbook data, it appears that deal count remains steady although dollar volume is decreasing. In addition, valuations peaked in Q4–21. Based on these trends, it’s safe to say that capital will continue to flow, just with a bit more restraint than in the previous couple years. We can expect valuations to come back to Earth and anticipate some down rounds from some of the richer valuations normalized during that period. Nevertheless, venture capital is in a unique position to continue funding the best and brightest. It’s less a matter of deploying fast, but picking winners and doubling down on the entrepreneurs built for resilience, revenue and reality of the times.

Kyle O'Brien