I have put off writing a post like this for a while but after several confidential conversations, I realized that the funding market for tech startups will continue to deteriorate and founders are not prepared for the new normal.
The days of easy money in venture capital are gone for now
Founders realize that funding rounds in 2022 took longer and were done at lower multiples than in 2021. What founders have yet to internalize is that the funding environment will continue to deteriorate well into 2023.
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No one can predict when the funding markets will stabilize but when they do the new normal will be significantly different than the 2020/21 period. A new normal will likely include:
- Valuation multiples closer to long-term trends than 2021:
- SAAS multiples will more likely be in the 10x to 15x next twelve months revenue as opposed to 30x+.
- Marketplaces will more likely be 2x to 4x annual GMV than 10x+.
- Term sheets will include more governance terms.
- Deals will take longer than 2 to 4 weeks to complete.
- Diligence for later stage companies will focus more on the end state of the company. What evidence is there that the company can scale to $100m+ revenue? If it can scale, what evidence is there that it will have high gross margins and strong cash flow?
We should not be returning to the post dot.com world
Some founders are worried that we will return to the post dot.com world where it will take 10+ years to recover. While we are entering a more subdued funding period, the world is different and we should not see a repeat of 2001.
- Technology is more pervasive across society. Both consumers and enterprises are quicker to adopt new technologies.
- Human capital in the form of teams that have previously scaled companies have the experience and know how to adjust to the current environment.
- Unlike 2001, private markets, not the public markets, fund growth. The private market still has capital and an incentive to deploy it.
- Generative AI is emerging and being adopted rapidly. Blockchain may find a strong value proposition. Enterprises are looking for technological solutions to some of the most daunting societal problems like climate change and the aging population.
How can companies adapt to the new market?
The simple answer is to efficiently build a massive business with strong cash flow that customers love. Of course, most companies were trying to do that already ;)
What is different now is how you get there. A startup creates value by removing risk while growing revenue. Previously the key thing was growing at all costs. Now companies are being judged on their capital efficiency and the ability to grow quality revenue.
What is quality revenue? Repeatable revenue that produces gross margins and produces strong unit economics (high LTV/CAC, quick payback period).
The question now is what do you prioritize to stay alive and get to your next round or cash flow positive. This depends on several factors:
- Do you have proof of product-market-fit? If so, do you have a scalable go-to-market channel?
- What was the multiple valuation of the last round compared to current valuations?
- What does your current KPI imply about your current valuation compared to your last raise?
- How many months of runway do you have?
If you have product-market-fit you are in good shape as long as you did not raise at a too high valuation last round. If this is the case and you have a scalable go-to-market focus on growth while removing any investment that does not lead to growth. If you lack a scalable go-to-market reduce burn significantly and focus on rapidly testing different go-to-market strategies to find a scalable one. In either of these situations, the traditional 18 to 24 months of runway should be sufficient.
If you have product-market-fit but you have a valuation problem the priority depends on your funding situation. Do you have enough runway to grow into your valuation? Then follow the advice in the preceding paragraph. If you don’t have enough runway you most likely can’t cut your expenses to safety. You have to talk with your current investors about raising capital on the most favourable terms possible. How much you need to raise depends on how many months of runway you need to grow into your valuation.
Don’t have product-market-fit? It is simple, cut back your team to people who can build the product and people who can sell the product. Then iterate away. Your activities should focus on customer development feeding into iterations on product, go-to-market, and positioning. Keep the team and costs as low as possible until you have signs of product-market-fit. Your situation may be further complicated by a valuation overhang. In that case, you may need to go into cockroach mode for a year or two to get to product-market-fit and then grow revenues to enable you to raise another round.
The upside of the new reality? Companies that survive will be more resilient, be quicker to adapt, and most likely see their founders and employees capture more of the value they create.
