Shasta Ventures partner on the 'brain damage' that happens when a startup's value crashes

Nihkil Basu Trivedi got his start as an entrepreneur early: in 2009, during his sophomore year at Princeton, he founded a startup called Artsy that helps art collectors find contemporary works. Artsy is still going strong today with over 100 employees.

He joined Shasta Ventures in 2012, where he focuses on consumer tech startups, plus education, health care, and other areas of interest.

We talked to Basu Trivedi - that's his full last name - for our feature on what happens now that Silicon Valley has moved out of its latest easy-money boom cycle.

Here's a lightly edited version of our conversation:

Business Insider: Describe what's going on right now in Silicon Valley. Is there a big change afoot?

Basu Trivedi: The venture community has realized that a number of companies were funded at valuations that were far ahead of their fundamental progress as businesses, and that some of those companies are not actually that great fundamental businesses ... The ones that are not great might ultimately be zeros, so a bunch of people are going to lose a lot of money. The ones that actually might be great might still be able to survive as a result of that, but their last round valuation is a potential handicap to them being able to survive because they might need another round to survive.

A number of companies will fail because they won't be able to raise a next round, they're just not great businesses, they're being outcompeted, they're losing money on every order.

BI: What about raising a down round? Can't companies do that as a last-ditch effort to survive?

Basu Trivedi: Sometimes the gap is so wide, and there are so many egos around the table, that just doesn't happen. Or instead of doing the brain damage associated with a down round and a total recap [recapitalization], they just sell the business.

A lot of companies will survive because they scrapped together a round, and some of those rounds will be recaps. I've heard of companies already that have gone from valuations in the tens or hundreds of millions of dollars at the last round, to being in the single-digit millions pre.

BI: Does it matter if you recap? What's so bad about it? Doesn't it give the company a chance to survive?

Basu Trivedi: Often a recap is associated with a RIF [reduction in force], either pre the downround or concurrently with the downround. The business is not doing as well as it should be, it's not performed for whatever reason. There are often layoffs associated with it.

That phrase, brain damage, gets used over and over again when it comes to recap.

The key, though - what everybody has in their minds when they do a down round or a recap - is how do we make sure that the people around the table after that are incentivized to go for it? There's often a new option pool created as well, so that's even more dilution to existing investors, all the preferences get reset.

That phrase, brain damage, gets used over and over again when it comes to recap. You have to rally all troops to do it again.

It's particularly tough on employees who have left the company, exercised their options, bought shares, and those are all - if they're not worthless, then you're way underwater on that.

BI: Almost like starting over again?

Basu Trivedi: Yes. And that's almost how investors evaluate it. If you do a total recap at 10 million-pre [a $10 million valuation, before the added money of the new round] do we think it has 10x potential at 10-pre? Or 20x potential at 10-pre?

Say you've already as an investor put in 5 million bucks or 10 million bucks into a company, that's all gone anyway. That's sunk costs. The mentality of doing a downround recap is it's effectively a whole new investment. That's one way we've approached these kinds of decisions at Shasta, and I know how other firms have approached it. Pretend this is a brand new company....would we do it as a whole new investment?

But there's also shiny brand new company that just came out of YC that's raising at that exact same valuation. So the decision becomes, do you recap this thing that's got maybe a bunch of customers, technology, legacy stuff built, but you're recapping the whole thing and there's all the brain damage associated with that, or instead do you make a brand new investment in the brand new shiny thing, that's been around for only 6 months and is growing nicely, at same price?

BI: What about companies that sell mostly to other startups and their employees? Catering companies? Fancy bars? Real estate companies?

Basu Trivedi: If you talk to the investors who were around as the last dot-com bust of 2000 happened, there were a ton of businesses back then that were selling to startups.

There are good businesses that have SMBs [small-to-mid-size businesses], startups as customers, that are recurring revenue businesses that are must haves for those companies. You can't just get rid of payroll system or your HR function to cut costs. Obviously if you die, you churn.

We very much prioritize companies if they are selling into startups whether they're core, they're must-haves, they're daily habits and behaviors, versus things that might be just nice-to-haves.

BI: Have you been involved with or heard of companies cutting costs, cutting the nice-to-haves?

Basu Trivedi: I don't have a good top-of-mind example for you. My intuition suggests it's definitely happening...It's got to happen. There are so many companies that are burning over 500k a month, that means they're burning a million every two months. A million dollars is a lot of money.

BI: Where do you cut? How do founders make those decisions?

Tons of companies have been putting together RIF plans in last 3 to 6 months.

Basu Trivedi: The more impactful decisions if you look at burn are not food every day, they're people. So you start thinking about where do we trim? Where do we have fat in our organization, and the first to go is the trimming of the fat. Then in some cases, to make the business work, you have to go deeper into the muscle, and all the way close to the bone.

Then it becomes prioritization, we look at engineering, and marketing, and customer success, and sales and all the different functions. Who are the strongest performers and not the strongest?

Tons of companies have been putting together RIF plans in last 3 to 6 months. And a lot of those are first-time founders who have never done a RIF before, so there's a ton of inertia and worry if we make RIF and we're going to lose our growth engines. Because were going to cut these couple marketing people. Or we're going to cut engineering and that means our product's not going to get better at the pace it needs to get better. That's where the really tough discussions happen with the board.

BI: When you look at potential investments, is there more scrutiny today?

Basu Trivedi: Yes, there's more scrutiny today than there was 12 months ago around the fundamentals of the business.

I think 12 months ago, I don't know if we invested in companies based on this, but we certainly took seriously some companies that we wouldn't take as seriously today. Because we were kind of worried about the unit economics 12 months ago, but maybe we felt like the consumer pain point was so huge, and the potential for it to grow explosively high, so we might have overlooked unit economics. Where today we are focused on the unit economics/gross margin question.

...Obviously, there's going to be less on-demand company investments. It's partly because of this unit economics question. It's also because people are looking at a company like Uber and Uber Eats and the things that it can do and realizing, man, when you have economies of scale, it's really hard to compete.

BI: When will things recover? How will this play out?

Basu Trivedi: Quoting our partner Doug Pepper - It's not like there are dark clouds. There's so much fundamental innovation that's going to happen in the next couple of years...

Autonomous transportation, that has the potential to generate trillions of dollars of value across so many industries, also lead to a lot of lost value for incumbents that are going to be disrupted...A lot of interesting stuff around consumer finance, around health and medicine...

What Doug said, "it's not as if there are dark clouds, it's just that the rainbows have gone away."

BI: Any bright side to all this?

Basu Trivedi: Hiring might become a little easier. If you have raised money then there's potentially less competition. It's more of a moat than it was. That's like a haves vs. have-nots situation. That's good for the haves.

BI: Any good news for the have-nots?

Basu Trivedi: If you look at it historically, the best time to start the next generational company has always been out of the ashes of correction.

BI: How long will it go on?

Basu Trivedi: I think we're going to be in this mode for next year and a half to two years. I don't see that changing because exits are not going to suddenly flood in. Everyone's being measured right now.