Adapting Your Pace to a Changing Race

During the recent prolonged bull market we’ve been experiencing, there are two trends around achieving funding rounds that both VCs and entrepreneurs have become accustomed to: the decrease in startup KPIs, and the increase in investment amounts. To help navigate the new environment we are finding ourselves in, it will be critical for startups to understand that what we’ve experienced until now is reflected in these two trends, and to realize the fact that these two trends are completely reversing.

The first trend concerns the decrease in KPIs that start-ups have had to reach in order to attain their next round of funding. Let’s focus on the revenue metric for a B2B enterprise software company (there are obviously many metrics to look at). Once upon a time, for a Series A, you were expected to demonstrate $100K MRR in billed revenues. Over the last few years this KPI moved from ‘billed revenue’ to ‘booked revenue’, then from $100K MRR to $1M ARR, and eventually to first installations in customers with a projected $1M ARR — 12 months away.

The second trend concerns the increase in round size. There is a lot that has been written about this, but simply put, years ago, the average for Series A funding was $6M-$8M, which grew to $10M, then to $12M and eventually hit $18M by mid-2021.

Both of these trends, which are evident across nearly all funding rounds and verticals, were ultimately caused by supply and demand shifts in private market capital. And while there are clearly nuances in different verticals and geographies, the combination of the two has been dramatic: start-ups were given more money to achieve less. In fact, the impact is even more profound: start-ups have been raising their rounds with a model of achieving KPIs suited to that time period, only to realize six or twelve months later that they are already being offered their next funding round, which in turn is even bigger than initially expected.

These start-ups set out to run a marathon, only to realize that the finish line is moving closer and the prize at the end is getting bigger.

But what happens now when these trends suddenly reverse? The marathon runner is now realizing that the finish line is moving away rapidly and the surprise boost (shorter run to the finish line) may not actually come.

Here are several strategies we recommend to our earlier-stage portfolio companies to adopt:

Don’t bank on the market flipping back in the near future.

One must first come to terms with reality. It’s good to be optimistic but building your business around optimism is something else. Importantly, do not expect this to be another ‘start of Covid-19’ situation, whereby everyone around you says the same things they are saying today but three months later the situation has passed, and we’re back to a hyper bull market.

The implications here are vast. Going back to our marathon runner — if her finish line is or has moved further away, it’s critical she notices this as early as possible. Otherwise, she is likely to complete her 26.2 miles run, collapse on the floor waiting for water and a masseuse, only to realize the finish line is at mile 35…

Figure out your valuation in today’s market

This is the question we are getting most from our start-ups and I fully understand the frustration — as an early stage investor it hurts me too.

I constantly hear: “The last round was priced by a smart investor who told us that if you execute the agreed-upon plan, our new valuation would be at least 3X that (from Post to Pre). We did our part. So why should the valuation not be at least 2.5X or 2X or any multiple of X??”

Unfortunately, the answer to this question requires redefining X itself rather than any multiple of it.

How to do it? Consider three or four publicly-traded companies that you think are most similar to what you are building (obviously no one is exactly like you, but consider those with similar verticals and similar business models). Use their publicly-traded multiples to gauge what your valuation should be. If you are very early on, try and work backwards from a fundraise you will do in two rounds from now and use the multiple on that one, then assume each round investors will expect 2–3X from Post to Pre.

This is not always a fun exercise but the benefit of having your valuation tied to the market allows you to keep your private company with its finger on the market’s pulse.

Or in our marathon runner’s case, it’s a way for her to keep track of the finish line and how it keeps moving.

It’s hard, but prioritize being efficient (if need be, take one step back to go two forward)

Once our marathon runner knows she has to run 35 miles and not 26.2, she is likely to act very differently; conserve energy or maybe even stop for a stretch if she thinks she will develop a cramp.

Efficiency is something that start-ups in all environments strive for, but now the priorities have changed. It’s not just growth at all costs. Be prepared for future investors to ask more efficiency- related questions and to test your model of not just becoming a large successful company, but one that does so in a capital-efficient manner.

Watch the price-per-developer

In the new environment, we are likely to see companies cutting departments or simply slowing their pace of hiring. This is likely to rebalance some of the salary inflation that we have witnessed in recent years. This variable may lag, but is likely to reduce start-ups’ costs over time.

For our marathon runner, imagine she has been told that there is a reasonable change that soon each step might cost her slightly less energy.

Note: this is true for all employees but given the cost structure of most of our early stage start-ups and price inflation specifically witnessed in engineering positions, it is the one I am most keen to monitor.

In times like these, agility is more powerful than skill

Of our start-ups, the ones who did best during the pandemic weren’t necessarily the ones that were best-placed at the beginning, but rather those who reacted fastest. An advantage nearly all start-ups have over their incumbents is that they are more agile. When there is an earthquake, they are better built to land on their feet, find new opportunities and adapt. Don’t be afraid to do so.

In fact, we can look to the most famous pair of marathoners out there — the tortoise and the hare — to find an example of how skill and speed alone won’t guarantee your first place at the finishing line.

In this new landscape spread before us, it shouldn’t be assumed that the most experienced, fastest runners will win. It’ll be the ones who are dedicated enough to exercise agility above all.