Terry Lee

The Grand Reset: VCs and LPs Are Starting To Internalize Reality The past few years in the VC space have been brutal. Darwin has returned from vacation and the frothy gold rush of the 2018-2021 startup ecosystem has vanished. The ZIRP environment caused valuations to soar and VCs threw money at any startup with a pulse. The money was put to work by Founders quickly, many of whom chased shiny objects and undisciplined growth because their bank accounts were flush with cash. But a harsh reality set in once we entered a new and higher interest rate economic cycle at the beginning of 2022: The vast majority of the high-flying ZIRP era startups are unlikely to deliver great financial outcomes for their investors and employees. Early in the correction cycle there was a lot of denial by Founders, VCs and LPs, but this denial has for the most part gone away. For many startups it’s clear that it will be challenging if not impossible to earn their way into their last valuation. For many investors it’s clear that they’re playing to recoup their money (i.e. – playing for pref) rather than playing for “fund returning outcomes”. And for many LPs, they realize that this is an industry wide phenomenon because every active fund manager played the game that was on the field. This has birthed a phenomenon that can be thought of as "The Grand Reset" where everyone in the ecosystem is seeking the cleanest path to a “do over”. Venture capitalists know that they have one or two funds that are going to underperform but are excited about their front book opportunities. So the “new deal” they’re making with LPs is that they’ll try to quickly recoup what they can and make the most of the back book in return for being more disciplined going forward. LPs understand that more investments than normal will fail and they know that absorbing those losses will lead to lower fund performance. LPs realize that the VC asset class is cyclical and great vintages can be created by great managers once the ecosystem flushes out the mistakes produced in an abundant and free flowing capital environment. The “new deal” they’re making with VCs is that they’ll forgive a bad vintage if the VCs will be honest with them about what the back book is “worth”, be more disciplined going forward and they’ll do everything they can to return some cash “soon”. And many Founders have realized that the ZIRP funding environment hurt their startups in multiple ways. First, their common equity is likely buried under a massive preference stack. Second, too much money caused them to hire too many people and invest in too many projects and undoing this has been challenging. Third, raising capital when a company has been in “shedding mode” rather than “growth mode” is difficult which puts re-booting growth at risk. And finally, the opportunity cost of trying to fix a broken business vs. starting a new one from scratch makes sticking around “expensive”. The net result of this “Grand Reset” is that there’s no longer incentive for anyone to maintain the illusion they can shepherd mediocre companies towards billion-dollar IPOs that aren’t going to happen. Instead, the focus has shifted towards "landing the plane" for the 90% of companies that aren’t ever going to achieve escape velocity. This generally means navigating an acquihire for struggling companies and helping “good but not great” portfolio companies find exits through acquisitions or mergers even if it means selling for a fraction of their inflated peak valuations. This shift can be brutal for Founders who envisioned a triumphant IPO. But for many, it's a wake-up call. The pressure to "grow at all costs" has receded, replaced by a need to focus on building sustainable businesses with real revenue models and clear paths to profitability. And "The Grand Reset" isn't just about selling off inflated companies. It's about resetting expectations on all fronts. VCs are re-evaluating their investment theses, focusing on strong unit economics and caring about capital efficiency. Founders are being forced to build businesses that can turn over cards in a disciplined way and survive without the crutch of endless VC funding. And LPs are seeking to re-up with Funds that have great pre-2018 track records and have a true competitive edge in today’s new normal environment. This new landscape has its downsides. The flow of easy money has dried up which makes it harder for promising early-stage startups to secure funding. But there are upsides as well. The emphasis on fundamentals could lead to the creation of a new generation of startups built on a foundation of sustainable growth, not just hype. The Grand Reset represents a significant course correction for the startup ecosystem. It's a painful process, but it could ultimately lead to a healthier and more sustainable future for both VCs and startups alike. As the dust settles, one thing is clear: The era of easy money is over. The startups that emerge from this reset will be the ones that can demonstrate real value and build strong businesses for the long term. (More on "landing the plane" in a thread next week).