Back to Square One

This past week I realized just how badly the venture capital industry has been hit by the recent downturn. Stock markets are down about 25% overall from their peak. Major tech stocks seem to be down about 35% on average, with a few much worse. The picture is most bleak for recent tech IPOs, those within the last year, which are down about 75% on average. What’s not immediately obvious is that this overall picture has wiped out many VC returns entirely. In speaking to a number of friends over the last few weeks and especially this last week, I’ve come to realize that many of us are back to square one. First let me explain the math.

While VCs are perceived as people who earn a lot of money, that’s not entirely true. A good VC makes the vast majority of their earnings through carried interest. Venture salaries, while certainly now low and still in the higher tier, are much lower than what someone in the industry would earn if they were doing another job, like working at a tech company or in finance. Like people who work for startups, VCs generally take a lower salary in exchange for carry upside. Really great funds can 10x+, while most good venture capital firms that can sustain realistically generate 2–3x returns, meaning $100k of granted carry could, after 7–12 years, turn into a few hundred thousand dollars and maybe even over a million, though that’s rare. Note that VC upside is much smaller that for startups. Early employees at successful companies can see their equity go up hundreds of times, hence why startup salaries tend to be the lowest — startups maximize the risk in the risk/reward trade-off, while venture capital splits the difference. As many, if not most startup employees may never see their equity go up or may see it go to zero, the same is true of the carried interest for folks who work in the venture capital industry.

Now, on the surface, it may seem like 75% drops in tech equities wouldn’t take VCs to zero. They don’t necessarily. But most funds, especially early stage, generate most of their returns on a single investment. Before any carried interest is earned, VCs must the return the capital raised. For returns in excess of that, they receive some percentage of the gain. Many funds were marked at 2–3x driven mostly by a single investment, or maybe two, that recently went public. A 75% drop from 3x driven by a basket of recent tech IPOs would put a fund at .75x return. While the fund’s equity position has not gone to zero, the amount of carried earned by the partners has actually gone to zero many funds have dropped back below 1x. There’s still time, and those positions could go up, and even a .75x return helps moves funds into the happy place of being in carry, but from what I’ve heard this week this scenario is far from theoretical — it’s actually what happened to many of us this past month.

One friend was going to make about $10m in carry due to a growth investment in Coinbase. Now they’re at zero. Another friend was valuing their carry as $3–4m in money due to an early stage investment in Terra. Now they’re also valuing their carry at zero. I was surprised to learn from many VC friends, I spoke to more than half a dozen last week and that sample of people probably averages eight years in the industry, that not a single one has ever actually received a dollar of carried interest. It’s a very long game, but if tech stocks don’t recover soon, it could very well be a never game for many of the current batch of VCs. The overwhelming feeling of many is that we’re back to square one.

No one is going to feel sorry for the VCs who treated their carry like their savings, and none of them expect anyone too. We should have always known that fortunes made fast can disappear faster. But the positive is that I am sensing what feels like a lesson learned. For so long, we had been operating on optimistic assumptions. The sense amongst my friends who had the most then lost the most is not that they are miserable, but that they are awakened. The VCs were not alone in this.

The results of a survey just came out showing that one third of Americans earning over $250k live paycheck-to-paycheck. There may be some unique circumstances in which those earning that much really couldn’t afford to live on much less, but it’s probably fair to say the vast majority have been choosing to live that way. I wonder if an economic downturn will change that. In my circles, I’m already seeing people talking talking of downsizing and moving. The belt tightening is real both for individuals and companies.

I’m observing many questioning the path they’ve been on and wondering if it’s time to start hunkering down for may be a long winter. One lesson is clear for all of us — whatever we may have had yesterday, we can’t count on having tomorrow. That feels like a hard, but very human way to live.