What turbulent markets mean for founders
Challenging Macro Environment
After a decade of low interest rates the Fed recently announced a 0.5% interest rate hike, the largest in 22 years, to combat high inflation rates and has also signalled that further increases are likely. The corrective actions central banks are undertaking won’t be quick measures, as well as bringing inflation under control the Fed is looking to run down its balance sheet over the coming months.
Against the backdrop of supply chain disruptions, inflation hitting cost of living and war in Europe the public markets have been struggling to adapt to the new normal and have seen sharp corrections to valuations and a general bear market sentiment has emerged.
While the large public indices are generally down 10% — 20% so far in 2022 the negative movement has been far more significant in tech, BVP’s Emerging Cloud Index is down 44% year to date. Public market sentiment has moved away from ‘growth at all costs’ to a tighter focus on profitability and free cashflow and those stocks trading at premium revenue multiples but with low profitability have seen sharp corrections.
This changing sentiment is filtering through to how companies set their strategy. Uber, which was virtually the standard bearer for the growth at all costs approach, has set out plans to slash spending and focus on unit economics in a recent email to employees.
How does this effect VC’s?
The immediate effect for VC’s has been a sharp drop in exit activity, the IPO window is firmly shut and exits planned for 2022 have been put on ice. According to Pitchbook Europe saw roughly one third of the VC backed IPOs in Q1–22 versus the same period last year.
VC’s will also be looking hard at the valuations of their existing portfolio, funding rounds which were done at peak 2021 prices may no longer look sensible in the light of the reduced public market comparables. This can translate through to mark-downs in valuation or internal funding rounds to extend runway to give more time for ARR to grow into the last round valuation.
We have also heard that multi-stage VC funds are refocusing their activity to earlier stage investments, where you naturally find higher growth rates and lower burns. The combined effect of VC’s shifting earlier and potential pull-back from cross-over investors tightly tied to public markets may result in a scarcity of growth stage capital in the markets over the coming months.
So what does this mean for start-ups?
The good news is that VC funding won’t go away overnight, VC’s are sitting on record levels of dry powder and some of the best venture backed returns ever came from companies backed during challenging market periods. The best companies in the market will still get funded, and probably still have competitive funding processes with attractive valuations, but investor risk appetite may reduce, and those riskier or borderline bets will be examined in more detail. So here’s what we’ve been discussing with the founders we’ve backed:
Growth is still king, but not at all costs
The first metric that VC’s will look at is still growth and growth expectations from investors are unlikely to decrease. We are though paying more attention to the efficiency of growth in start-ups, diving into unit economics and sales processes to ensure that growth is profitable, scalable and repeatable.
For founders that means doubling down on channels that you know work, where you can predictably generate new leads and convert them into clients. However, approach new channels with more caution, now may not be the time for a ‘big bang’ international expansion or new vertical. Your existing customers can also play a big part in delivering best in class unit economics, preventing churn and finding upsell opportunities are the key to positive Net Revenue Retention (a favourite metric of Conviction’s)
Be alert to changes in your customers
Many prospective customers, particularly those that are VC backed, in the tech space or consumer facing may be dealing with growth challenges of their own and more conscious of making large new purchases than in prior years. Proactively listening to customers and identifying segments at risk of longer sales cycles or complicated purchasing decisions can allow you to refocus your sales efforts before you are stuck in a quagmire.
Be open minded when planning your next raise
The market backdrop has changed significantly over the last few months and those effects will trickle right down to even seed rounds. Be open minded when planning your next funding round, don’t be anchored to previous valuation multiples and develop a plan that can still get you a step further down the track on a smaller round size.
A core part of our philosophy at Conviction is advising founders not to raise too much capital (& hence take on too much dilution) in one go, when your revenue and valuation prospects will improve with every month that passes. Concentrate on developing a highly credible plan that delivers efficient growth over the next 12 months which investors can get behind.
Be proactive
Don’t wait until your bank account is nearly empty to consider funding, check in with your existing investors and key targets for your next round along the way. The plan for your next fundraise can be a living thing that evolves as your perspective on the market appetite changes.
As with many VC’s we remain incorrigible optimists, we’re still actively investing and backing outstanding founders who can still build significant businesses despite challenges in the macro economic or fundraising environment.
