Sequoia’s message to founders: Focus on profitability, growth at all costs no longer rewarded

Sequoia Capital said that Morgan Stanley’s unprofitable Tech Index is down 64 percent since the start of 2022, compared to a 28 percent drop in the technology-heavy Nasdaq index, further signalling a strong preference for companies who can generate cash.

The VC firm said that while the Nasdaq has not fallen as much as it did during the dotcom crash and the global financial crisis, the story underneath the surface, that of non-mega caps, is more revealing as the non-mega cap stocks have declined ‘meaningfully’ more than the blue-chip tech index.

Sequoia said about 61% of all software, internet and fintech companies are trading below pre-pandemic 2020 prices and have lost more than two years of stock price appreciation even as many of these companies more than doubled revenue and profitability, suggesting that, the market is indicating that the valuation framework over the last two years is no longer relevant with the removal of free money.

The presentation further showed that nearly one-third of internet, software and fintech companies are now trading below the all-time lows of March 2020. The market is now pricing in lower values for many stocks than in March 2020, which was a time of peak uncertainty with the onset of Covid-19. The market bounced back quickly from those lows due to an unprecedented combination of monetary and fiscal policies, but as economies ae opening up and inflation is rising, governments and central banks are withdrawing their support, leading a rise in cost of money.

“Unlike prior periods,sources of cheap capital are not coming to save the day. Crossover hedge funds, which have been very active in private investing over the last few years and have been one of the lowest cost sources of capital, are tending to wounds in their public portfolios which have been hit hard,” Sequoia said.

“Many don't even have the capacity to invest, as the drawdown in their public portfolios has created an imbalance in their hybrid funds where their private investments (which have not been as dramatically marked down) represent more than the maximum private capacity within their funds,” the VC added.

Sequoia Capital said that there’s also a real economy risk with a weakening consumer that is weaning itself off fiscal stimulus while simultaneously dealing with rising inflation.

“But, what works in any market, is consistent growth and disciplined financial management that translates into improving margins,” Sequoia Capital said.

Companies who move the quickest have the most runway and are most likely to avoid the death spiral, the VC firm said. Do the cut exercise. Reduce costs on projects, research and development, marketing, other expenses, Sequoia Capital advised.

“It doesn't ‘mean you have to pull the trigger, but that you are ready to do it in the next 30 days if needed,”said Sequoia.In 2008 all companies that cut were efficient and better. Don't view cut as a negative, but as a way to conserve cash and run faster,” the company added.

Naming the current situation as a ‘crucible moment,’ Sequoia said, “it is hard to predict the future, but whatever happens, we want to give You a framework to emerge from any Crucible Moment stronger.”

Sequoia's letter comes at a time when many venture capital and private equity firms (PE) are sending out messages to investee startups, advising them  to cut excess costs, hire conservatively, and focus on profitability. PE/VC firms are also suggesting startups that need funds to survive to raise immediately without negotiating much, in order to sustain.

Last week, Moneycontrol had reported that marquee Silicon Valley startup incubator Y Combinator warned its portfolio companies about the worsening macroeconomic situation and advised startup founders to take money from investors even on terms of their previous rounds, if available. In a similar letter, venture capital fund Orios Venture Partners advised its portfolio startups to become conservative in hiring as it said the capital will be constrained for the startup ecosystem amid the bearish mood of investors.

For the Indian startup ecosystem, the letter is significant as Sequoia Capital has been a prolific investor in India and Southeast Asia over the years. The company has backed as many as 30 of the country's 100 unicorns to date.

However, valuations of Indian tech startups in both public and private markets have corrected significantly, amid a slowdown in the global financial markets. Many companies, including the ones backed by Sequoia, have also delayed their fundraising or IPO (initial public offering) plans. Singapore's B2B (business-to-business) e-commerce company Zilingo and homegrown fintech unicorn BharatPe, have also come under the regulatory scanner this year due to corporate governance issues.

Sequoia Capital India, a subsidiary of Sequoia Capital, is eyeing a $2.8 billion fund for India and Southeast Asia, Moneycontrol had reported earlier this year. However, a recent media report by the Economic Times said that the venture capital firm has pushed back the first close of its fund amid an ongoing probe in one of its portfolio companies.