Turnaround Venture Capitalists See Opportunity In The Current Downturn

Most startups don’t make it. While some companies fail because they are trying to solve a problem that doesn’t exist or trying to target a market that’s too small to produce profits, many falter because they aren’t growing quickly enough to attract or retain VC backing. Lauren Bonner calls these companies thoroughbreds — the unsexy workhorses of the industry — and her firm MBM Capital supplies them with capital when their other backers abandon them. If venture funding continues to cool off, she predicts the market will soon see a number of worthwhile companies needing help.

In April, $47 billion was invested into startups globally, according to Crunchbase data, the lowest monthly total in 12 months. Funding declined at every stage all the way down to seed. Future unicorns will still be able to raise in this environment, but many startups will struggle as VCs start to refocus on just a handful of their portfolio companies after last year’s funding fever.

Bonner defines the thoroughbreds among this group as startups with sticky customer bases and great products that may have hired too many salespeople or expanded into too many verticals to maintain solid growth. MBM Capital is currently raising its debut fund to take majority stakes in such companies to help them restructure, reach profitability and secure a better exit. This strategy isn’t new — one of MBM’s limited partners has been doing it since the 1980s. It did well throughout the bull market of the past decade and 2021’s frenzy. But 2022’s market looks very different, and Bonner is convinced the sector is ready for a bull market of its own.

“We knew that this would happen,” Bonner says about the current correction. “We started [MBM Capital] a year ago. When we were talking to investors saying we think there is going to be a correction in venture, most investors thought we were kind of crazy.”

While some investors are still hoping the current market volatility will be just a blip, Bonner and her partner Arun Mittal think the market is more likely to be looking at a pullback for at least the next 10 quarters — if this downturn looks anything like the dot-com bubble. Venture lenders must agree, as they are already driving a 3x to 4x increase in deal flow to MBM compared to the end of 2021, Bonner says. “We have been building the ark and the floods have started,” Bonner tells Forbes. “We are speeding up construction on the ark and are ready to set sail.”

MBM targets companies that have raised their Series A, are pre-Series B, and are growing 10% to 15% a year. The strategy mirrors the work of middle-market distressed debt investors and includes many of the same processes like helping companies trim headcount, lower overhead costs and tightening a company’s focus just on a smaller scale.

MBM is the newest firm looking to execute this strategy – but not the only one. Denver-based Stage Fund started operating a form of the strategy during the fallout from the financial crisis in 2009 and raised its first equity fund for special situations in 2020. And Julian Giessing founded Ginkgo Equity in 2020 after noticing several companies through his consulting work weren’t going to be the next Spotify but were great companies that needed the kind of guidance VC investors tout, but don’t always supply to their whole portfolio.

“I don’t want to finance these companies for the next five to 10 years,” Giessing says. “I hope there is a path to profitability within 18 months. Then companies can start focusing on growth and using cash that is generated rather than just covering up losses all the time.”

The strategy has successfully saved companies like retail tech company ThirdChannel, which was almost a victim of the two-week funding pullback in March 2020. When the pandemic hit, the company, a retail and ecommerce workflow solution, was about to start raising its Series B round and was just months away from being profitable. They just needed a little more time, CEO Brian Tervo tells Forbes. But in the wake of retail’s uncertainty, their investors weren’t willing to help them get to the finish line.

“Our business model was working, we were going to be profitable,” Tervo says. “We were just looking for some way to keep the company going.” Stage Fund took a majority stake in the company in November 2020 and got to work. The fund took over ThirdChannel’s HR and finance practices, laid off management and staff, and returned the business’s focus back to its core product offering. Within a quarter, they were back on track and have since started turning a profit.

“We doubled our business last year and we will probably double it again this year,” Tervo says. “That puts us in a perfect space for a growth round. We found a kindred spirit in Stage Fund.”

While the strategy has the potential to be transformative for companies like ThirdChannel, it’s also a potential goldmine for investors. Instead of hoping a few companies return the portfolio, turnaround VCs expect the majority of their investments to produce solid returns. “When we look at our portfolio, we say 50% of our companies at their worst should deliver a 3x to 5x on their capital,” Krista Morgan, a general partner at Stage Fund tells Forbes. Morgan adds that she could deploy $1 billion to this strategy if she had it.

This strategy isn’t for everybody — companies and venture firms alike. Some founders may not want to give up the control this model requires or to trim staff or research and development initiatives. For firms, despite the predicted solid returns, these investors most likely won’t ever achieve the level of return a seed investor in Uber or Coinbase would. Plus, this turnaround process is hands-on and time consuming. Ginkgo, Stage and MBM all say their firms can realistically only take on up to three such deals a year. But, if 2022’s funding trends continue, this strategy might be one of the more successful.

“It’s going to be really interesting to see how this plays out,” MBM’s Mittal says. “The dot-com bubble and the 2008 crash, there was a correction for two to three years. We are in the early innings. We are seeing more deals than ever. Founders are really looking for partners and a different way to grow their business. It’s a good time for what we are doing.”