Much has changed in the past four months of the technology startup world and how outsiders value the business. Of course it is too early to predict whether this is a trend or an aberration but the smartest people I know in the industry are predicting the former.
The startup industry may be “resetting”, which does not mean a crash but rather just a resetting of valuations, timescales, winners and losers, capital sources and the relative emphasis of growth rates versus burn rates.
As we noted in our survey of more than 150 VCs we know in the industry, many saw drops in fourth-quarter valuations last year, with nearly all of them projecting decreases in 2016.
And when prices are dropping on a VC’s existing companies in market, there is a substantial reduction in the fear of missing out on new deals, which means that investors take their time in making investment decisions. Deflationary economics are well understood – in a market where prices are dropping, one prefers to wait a few months to see if prices stabilise before committing. We do this in our consumer lives with everything ranging from housing purchases to public stocks.
Why does this matter?
The single best – and most important – article I have read on the topic was published by Joseph Floyd, asking whether Black Friday was a “DiSaaSter” or a reversion to the mean. That is economics – or statistics – for asking whether price ratios of how investors value companies were simply coming back to historical norms. You should read the article but I will provide the money shot.
So here is my take-away.
• If you raised money in the past two years and have grown, it is possible that your next round valuation might be flat or lower even though you have a higher revenue because investors may value your multiple differently.
• Investors are rewarding cautious growth more than high-burn-rate growth at all except the most successful of companies, and even there it may eventually change.
• The smartest companies in the market that I know are working aggressively to lower burn rates through pragmatic cost-cutting, knowing that the next fundraising cycle may be unpleasant. This prudence is smart and welcome.
• I have heard enough companies say “we simply cannot cut costs or it will hurt the long-term potential of the business” to get a wry smile. We entrepreneurs have been spinning that line for decades in every boom cycle. It is simply not true. Pragmatic cost cuts are always possible and often productive.
• If you can get a round done at the price you expect, well done. I am not rooting against anybody. But I would point out that raising money is an existential event and I think in the coming 12 to 18 months you may see loss ratios – companies going out of business or selling in fire sales – go up. So if your fundraising is not moving, consider lowering price to shore up your balance sheet and reduce risk.
• Do not assume you can “just do a down round” if necessary. Down rounds are corrosive. Insiders hate them and fight them. Outsiders hate them because they are worried about pissing off your existing investors. Employees hate them because it is hard to reset expectations that their stock is worth less. Founders hate them because they are dilutive. The terrible consequence is that some great companies struggle to get financed. New investors often prefer to back newer companies that have never been through this drama.
In my mind this simply means:
• Start early.
• Give yourself enough runway but controlling costs.
• Be realistic on valuation.
• If you need to clean up your own cap table first – while very hard to do – it will make outside funding easier.
• If you have not raised lots of money in the past, be very thoughtful of the trade-offs between easy money – party rounds, crowdfunding, leaderless deals – at higher prices versus more committed capital that can be lower price and harder to raise but more committed in tough times. I am a VC, so this will be seen as self-serving. But given that I am not likely to back 99.999% of the people reading this – I do two to three deals maximum per year as a VC – I am really just trying to offer honest advice.
The days of easy money may be slowing down. And please consider reading Joseph’s article on TechCrunch. It applies to all startups – not just software-as-a-service.
Great companies will continue to be built and many will tell you that building a great company in capital-constrained markets in some senses builds a more sustainable company. The best deals will continue to get financed. This is not a fire alarm, just a message to less experienced entrepreneurs that the capital markets may have begun to change and if you are not aware of how this could affect you then you could be a casualty. The last few funding corrections saw many great companies disappear due to bad capital planning and high burn rates.
This is an edited version of a post at www.bothsidesofthetable.com/2016/02/08/the-resetting-of-the-startup-industry