A Flight to Quality in EdTech Venture Capital?

The last year has been an interesting journey for me in the world of venture capital. I had come in contact with it in various ways before but not nearly as intimately as I have as the co-founder of a start-up. While I’m still very much a novice in the space, e-Literate has always been about sharing what I’m learning rather than what I know. At this point in my journey, I feel I have learned enough to take an earnest first stab at analyzing the changing EdTech venture capital market and making a few suggestions.

I freely admit that this post is motivated partly by my direct experience as a fairly new founder and that it is self-serving in the sense that it reflects the ways in which my partner and I have thought about building our company.

Context and trends

The venture capital world is currently experiencing turmoil similar to (and somewhat tied to) the turmoil in the public stock markets. Companies that VCs invested in are becoming less valuable. Since it’s not at all clear that we’re at the bottom of that trend, investing in new companies now is tricky. And many of the investors in the market now have never faced an environment like the one we’re in now. Venture capital has had a remarkable decade-long bull run. The mid-level VCs, and even some of the general partners, were not in the game 22 years ago during the dot-com bust.

At the same time, higher education is also in uncharted waters. The effects of the pandemic were weird. Enrollments were down. But not equally everywhere. Increased adoption of EdTech was enormous. But not necessarily the products that folks expected to be big hits pre-pandemic. We don’t know what will happen with blended and online learning. I personally expect that it is here to stay almost everywhere. But in what balance? Will the technologies remain the same, or will they shift as schools move out of emergency remote teaching mode and focus more on brand and quality? What does it look like on residential campuses? Will students still pay for housing? Is the answer to that question different in different segments?

We are facing an economic slowdown and possibly a recession. As unemployment numbers revert to historical norms, will we also see the normal historical trend of education enrollment increasing counter-cyclically? It seems like it should, but I’m not sure. And will we see a move to more alternative credentials? I don’t know.

All in all, it’s a challenging environment in which to make risky investment decisions.

In the larger VC world, the flight to safety means investing in more profitable and less risky companies. And trying to buy these companies at a bargain. I suppose it’s roughly equivalent to stock market investors buying large-cap value stocks that pay dividends. And also like investors in the public markets, VCs are holding onto more cash.

But every sector is its own world with its own investment risks. Does flight to quality mean the same thing here as it does elsewhere?

Yes and no

The universal rules are (1) play it safe overall, (2) keep your powder dry, and (3) be ready to jump on underpriced opportunities. These apply everywhere, including EdTech. But what does it mean to play it safe in this sector, and how does one identify underpriced opportunities?

It’s hard for VCs to pick good bets in EdTech even in normal times. The sector is incredibly complicated, the buying processes are not rational, and sales often take a long time and a lot of effort without any clear signals of how likely a company is to make the close in the end. It’s also hard to tell from the outside if a company that makes its first five customers happy will attract its next 50.

On the other hand, we’ve already seen some seismic shifts in education over the past few years and there are reasons to believe that changes will continue. A sector that was very static for a long, long time is suddenly changing at a pace I have not seen in my lifetime. There’s good reason to believe that changes will continue and may even accelerate. That’s how punctuated equilibrium works.

Later stage investments in EdTech, particularly in higher education, are often companies that have co-dependent relationships with universities that are desperately clinging to the status quo. So, for example, any company that helps a university sell more enrollments without requiring them to fundamentally re-examine how their current activities and expenses align with their mission have tended to do well up until now. But if external forces are creating a situation in which colleges and universities have to change anyway in order to survive, then those “safe” bets may become less safe, not only because of financial conditions but also because of fundamental changes in the needs and priorities of universities.

To put this in perspective, it’s worth looking at a chart that Phil Hill recently posted to Twitter:

I won’t make too much of this chart here because doing it justice would require significant research and a separate post. That said, it’s worth noting for comparison that the NASDAQ composite is down about 13%, the price of Bitcoin—the currency, not the stock—is down about 30%, and the S&P Cryptocurrency Broad Digital Market Index is down about 53% in a one-year time frame. Every stock on this chart except Pearson and LTG has underperformed the NASDAQ. Instructure is down about as much as Bitcoin. D2L is performing slightly better than the broad crypto market, while Coursera, Chegg, 2U, and Zovio are all significantly worse.

The stock market chart isn’t an apples-to-apples comparison since this post is about VC investment rather than public stock trading. Nevertheless, Phil’s chart does raise more general questions for EdTech writ large: What does “flight to quality” mean in EdTech investing? What should (particularly higher ed) EdTech investors be looking at and thinking about as they try to make “safer” bets?

At the moment, most investment is on pause. Think about your own stock portfolio. Who is buying in this market? VCs have the same problem. The level of uncertainty is giving them pause. But that won’t last forever. How will VCs think about investment when they think it’s time to put money in again? And how should they?

Think about infrastructure

While investing in general—both public and private—always tends to be something of a fashion industry, EdTech has always struck me as being particularly vulnerable to fads and sex appeal. While I readily admit I have a poor grasp of sex appeal of any sort, this has always puzzled me. What are professional investors putting their money into right now in the public markets? Commodities. Nothing says “sexy” quite like copper and lithium, am i rite?

I understand that, in a market where the workings of the purchasing institutions are Byzantine and hard to analyze, thinking about macro trends is just easier. The intersection of micro-credentials and workforce seems like it should be a thing. Chatbots have a lot of general utility. Universities need help finding new revenue sources. But betting on these trends without understanding the underlying processes and obstacles is problematic. You can’t be a sophisticated investor in electric car stocks without understanding at least a little bit about the supply chains for the lithium used in the batteries, the microchips, and so on.

Educational infrastructure is as important as it is boring, particularly in times of rapid change. I’ll give you three examples.

First, before the pandemic, most people thought of Zoom as the thing they had hoped WebEx or Google Meet would be when they first tried those web conferencing apps. It wasn’t a revolution. Just a relief. Certainly, there was plenty of evidence in education that web conferencing wasn’t considered a big deal. Back in 2010, Blackboard CEO Michael Chasen acquired the two dominant education-specific web conferencing apps: Wimba and Elluminate. It was considered a bold move, buying up the only two major entrants in the product category. The two were rebuilt into one product, branded as Blackboard Collaborate and, eventually, rebuilt a second time. It sold…fine. To Blackboard customers. It certainly didn’t do well enough to change Blackboard’s fortunes. Not in 2010 and not in 2019. Fast-forward to the pandemic and Chasen decided the next big app is going to be…Blackboard Collaborate. Only built on Zoom. And in short order he was able to raise $164 million to fund it.

Note: I wrote the first draft of this post before Chasen’s new company, Class Technologies, announced that it is buying Blackboard Collaborate for $210 million. While that development merits its own post, the main takeaway for the purpose of this one is that Chasen was able to raise a new investment round to make that purchase.

Anyway, this story is one of buzz riding on a real infrastructure trend. Zoom is obviously the infrastructure. Reliable, easy, scalable webconferencing suddenly became a necessity in education. The trend was there. It was visible. Zoom’s education revenues soared. So Chasen’s new company, which adds Blackboard Collaborate-like features to Zoom, got tons of investment money. Because it’s the Zoom of education! Time will tell if his company turns out to be a good bet or just gilding the lily. The more important lesson here is that the underlying infrastructure—Zoom—which everybody thought of as a niche product—suddenly became incredibly important when circumstances changed rapidly. As painful as pandemic schooling was, it would have been vastly worse without webconferencing that mostly just worked.

The second story is alternative credentials. Universities have awarded certificates for a very long time now. You know who hasn’t kept up? ERP vendors like Oracle and Ellucian. It took them a decade to be able to handle both degrees and certificates. And when I say “a decade,” I mean the last one. Come to think of it, it was more like 15 years.

Were there upstart competitors that could handle alternative credentials? Yes. But they couldn’t handle all the other stuff that the traditional ERPs do and anyway, switching costs for ERPs are incredibly high. So colleges and universities with certificate programs often ran (and still run) two separate systems; one for regular degrees and one for alternative credentials. It’s incredibly expensive in dollars and person/hours.

Do you think that this state of affairs has slowed the pace of colleges developing alternative credentials?

I do.

Third—this one is top-of-mind for me and my Argos colleagues—there’s the textbook industry. Everybody loves to beat up on the big publishers and label them as failures. That is fair by several different measures. VCs are allergic to challenging them because of Knewton, which was a massively costly failure, and a generation of other courseware companies that didn’t produce the payoffs their investors were hoping for, including Acrobatiq, CogBooks, Smart Sparrow, FlatWorld Knowledge, and Boundless, among others. And yet, private equity seems to love this sector and is making a lot of money in it. Furthermore, whatever the failings of the incumbents may be, a lot of smart people have tried and failed to knock them off their pedestals. Their durability despite their flaws tells us something interesting about the strength of their value to their customers at some level. But again, a lot is changing quickly in the market. What is the essential function of these businesses that makes them infrastructure? Where are they failing to meet needs? And what’s changing that may open up new possibilities for providing infrastructure in a better form?

Whenever you see higher education institutions failing to do something that you think is obviously valuable or tolerating pain that they shouldn’t have to put up with, there’s a good chance that barriers exist under the surface that will not always be visible to VCs. Removing these barriers isn’t easy, isn’t sexy, and can’t always be solved with products and services. But sometimes it can. Not as a magic widget that suddenly makes everything work but as a communication or workflow tool—as infrastructure—that enables humans to work differently. Find the problem underneath the problem. You can only do that by talking with the people who throw themselves against that brick wall repeatedly, trying to crash through it. Talk to the university folks who are tasked with doing that which should be possible but apparently isn’t for some reason.

Quality EdTech companies show a deep understanding of how their customers work and the obstacles preventing them from achieving positive change at an inflection point for their sector. And this quality of thinking isn’t necessarily going to come through in a pitch deck because it requires a conversation about context that the investors often don’t have.

Think about the Great (college) Resignation

It’s hard to disentangle all the various causes of enrollment drops and assign percentages to them. But zooming out to the bigger picture, it seems clear to me that many students are engaging a kind of soul searching similar to people who are participating in the Great Resignation. For a long time now, workers haven’t been happy. Maybe their pay is too low. Maybe they live someplace they don’t want to live. Maybe their job is unsatisfying. But they have tolerated it.

Until they didn’t anymore. Some reached a breaking point. Others found unexpected opportunities in the new economic landscape. For still others, it was a combination of both.

I think a similar change is underway with college. Many more students are more practical-minded than my generation was. They think about cost. They think about value They think about job prospects. They think about balancing campus life against other things they care about.

They think about what they want from college.

When I was in high school, I didn’t think at all about alternatives to going directly to college and I didn’t think too deeply about what I wanted from my college experience other than…a college experience. I thought a little bit about big versus small, far away versus close, and price. But not too much about any of those things.

Today’s students want effective, affordable education. And we know many of them need a sense of connectedness to succeed, even if they are in a physical classroom less often (or not at all). In the new world, only the very top tier of college brands will hold up without some re-imagination (and even they won’t be completely immune to the pressure to be seen as innovators). My evidence for this claim is admittedly anecdotal; I hear it from family, friends, and colleagues. While I’ve been skeptical about this trend until recently, the level of noise that I’m hearing convinces me that we’re finally entering the early stages of a turn.

Moving forward, quality EdTech companies will increasingly focus on efficacy, affordability, and quality of connection for students as central to their value proposition, because these features are rapidly becoming central to the value propositions of colleges and universities. Quality companies will also recognize that the Great Resignation is hitting faculty and staff too. Any product that can make their work experience more humane and increase college workers’ connectedness with their colleagues is a win. It makes the product sticky.

Think about company health benchmarks differently

I’ve already addressed one dangerous assumption: The EdTech companies—and business models—that have done well in the past will continue to do well in the changing environment. A second one is that risks go down as companies reach seven-figure revenues and become profitable (or at least show strong cash flow). These benchmarks go hand-in-hand with VCs’ high comfort level with enterprise sales models. All else being equal, it seems likely that investors will double down on these metrics during this time of uncertainty.

Here’s the problem: Enterprise EdTech has a massive growth gulf that most EdTech companies—and product categories—fail to cross. Most get stuck in the range of between $10 million and $50 million in annual revenues. Think of lecture capture companies. ePortfolios. Learning Object Repositories. Clickers. Learning analytics. Courseware platforms. [Fill in the blank.] Yet these product categories got funding before either plateauing or fizzling out.

If an EdTech entrepreneur starting a company today wants to live long enough to get to sustainability, what’s the best strategy for getting there with VC money? You pick a trendy niche where you can quickly get a few early adopters. You don’t go for anything that addresses deep problems or is complex to explain. Instead, you solve an immediate and obvious pain point. You don’t take time to think too deeply about the differences among institutions that make the market you can actually reach much smaller than it appears to be. You choose an enterprise license model to generate significant revenues from your first customers, even if it means slower growth later. Meanwhile, you under-invest in your product so you can afford to live on those revenues for a while. Instead, you focus on sales. You try to get pilots and small license deals. You do whatever you have to in order to win those deals, including building features that only one client wants. (But you build them cheaply because even enterprise licenses don’t pay much in EdTech.)

It’s hard to avoid building an EdTech startup with these parameters if you want to live long enough to hit the benchmarks for venture funding, particularly in today’s environment. But to reach those benchmarks, the chances are very high that you’ve designed your business in a way that will never, ever cross the chasm.

Investors need better quality signals. There is no magic bullet, of course. Part of the solution—it pains me to write this as a founder—is lower valuations. But another part is to think about the counterproductive incentive structures in the current system that discourages practices that enable companies to build for real growth. Pattern matching may not serve you as well as you think, particularly in a time of rapid change. Investors could benefit from getting a little outside their comfort level and looking for different signs that a company will continue to have legs, three, four, five years after closing their A round.

Quality EdTech companies design and build for the long haul. They think deeply enough that their solution should surprise you at least a little bit. They show their work with stories about a demonstrated need from customers and prospects that suggests product/market fit across multiple segments and stakeholder groups. (This requires a balance between focus and growth potential that is often non-obvious.) They think about how to avoid, or at least mitigate, the enterprise sales model’s pitfalls that are particularly difficult in education. And they have a plausible story about how they’re going to get enough cash flow and growth to get to profitability, even if it will take a while.

There will likely be significant burn rates early on, but not out of a push for revenue growth over profits. Rather, quality companies push for proof of scalable product/market fit over profits. That’s even more true today than it has been in the past. The big winners in a changing educational market will have to play the long game, particularly if they intend to help universities improve affordability, effectiveness, and connectedness for today’s (and tomorrow’s) students. It’s a structural characteristic of this particular market. While investing in early-stage companies carries inherent uncertainty, the complexity of the EdTech market means that underinvesting in early-stage ventures dramatically increases poorly visible risk at the growth stages that are traditionally viewed as “safer”. The data in A- and B-round EdTech companies, like revenues and customer growth, can be misleading because of product/market fit scaling challenges. Certain sectors, like energy and pharmaceuticals, are obviously capital intensive from early on. EdTech is (incrementally) more capital-intensive than may be obvious from the outside.

At least, that’s my sense of the situation. I’ll be curious to hear how much of this rings true to the professionals.