Fears that there is a looming funding downturn accompanied by plummeting tech stock valuations were stoked on July 1, when the Wall Street Journal reported that Klarna, a ‘buy-now-pay-later’ entity, was trying to raise fresh capital at less than a fifth of its peak valuation of $46bn. As Klarna’s attempt to raise funds implies, the long startup boom is going through a sharp correction and the surfeit of capital is rapidly drying up. The NASDAQ index, which is weighted towards tech companies, has fallen by nearly 30% so far this year in a gruesome reckoning.
Core economic metrics of rising interest rates and inflation, and the war in Ukraine are causing a wave of uncertainty to wash over the global economy. The FAANG group of tech companies – Facebook (now Meta) Amazon, Apple, Netflix and Google – has seen their combined share price fall 31% in the last six months. Fintech favourite Stripe has seen a 45% reduction in its share price in the same period. ByteDance, TikTok’s Chinese parent company, has its shares trading 25% below their value six months ago.
The startup funding bull run has gone into reverse, the startup moonshot funding party is earthbound. Such negative sentiment is buffeting startup tech firms hard as their horizon to cash breakeven lies far in the future, and the shock is rippling through the investment community as they seek to identify and nurture the next Google.
Yet over $600bn of venture funds were invested globally in 2021, ten times the level of a decade ago, and valuations rocketed as the feeling was that the good times would never end. Now investors are wanting their portfolio companies to hold cash in reserve and hunker down. Fledgling firms with little cash runway will fare worst, some will fail, others will hang on, some may prosper as founders learn to double down on their core business.
The Economist reckons all isn’t quite as bleak as it seems. Assuming a typical cash-burn rate, all but three of the 70 biggest software startups that have raised funds in the last 18 months have cash on the balance sheet to last three years, and nearly €100bn in European VC investment raised over the past five year has yet to be deployed, leaving plenty of ‘dry powder’. Alongside this, the number of successful entrepreneurs turned angel investors funnelling some of their tech wealth back into other startups, there may be some solace.
The signal in the near term will be the number of ‘down rounds’, where firms raise new capital at a lower valuation than their previous round, a definitive indication of falling sentiment. Whilst impacting the founders, they also hurt the morale of employees, who are often compensated with share options, and its irk VCs who are forced to mark down the value of their investments.
So, given the headwinds don’t look friendly, what are the immediate priorities for tech startups seeking to make their first foray into the early-stage funding market to focus on? Here are my thoughts.
1. Sensible valuations Don’t get greedy. We need to blend the outlandish ambition of founders with the sober and nervous disposition of investors. Show your startup has a genuine edge and innovation, an ambitious customer scaling roadmap, and a credible strategy to achieve cash generation. Investors need to take a ‘back to basics’ approach and educate entrepreneurs on the vital signs of an investable proposition, and not get lost in the SoftBank mindset which energised the WeWork and Theranos debacles of 2021.
Ultimately, your startup valuation is whatever you and your investors negotiate. Every startup is investment ready at a certain price, it’s a question on what the risk appetite of your investors is – the higher their risk appetite, the lower the expected valuation. Valuing your startup is much more a matter of negotiation than a mathematical exercise.
2. How to attract investors A startup is a bet on a business model attaining the scale at which the unit economics start making sense. Focus on determining the economic drivers of success, not outrageous revenue projections, and build a growth story around this. Within the growth strategy, investors like to see a capable team being shaped, a clear marketing strategy, and from this, a go-to-market sales focus with plan, resources and a target market research and customer personnas. It’s all common sense, don’t complicate it!
Looking ahead to turbulent times, we need more responsible distribution and stewardship of startup capital to improve overall macro-economic growth. The goal should be to make startup ventures sustainable, not just explosive, in a vibrant eco-system. After years in which VCs have cast themselves as infallible Merlins, in the scenario where investment funding is rationed, both sides need to focus on business fundamentals.
3. Have a clear growth strategy Think of scaling as building the base of a pyramid, the foundation upon which everything is built, and you know that it will hold. Focus on building your architecture in an intelligent way, without over taxing your cash or endangering your roadmap. I’ve always liked the McKinsey three-horizons framework for concurrently managing current and future growth opportunities which focuses on metrics, people and capabilities in the three horizons. The framework ensure innovation is not eroded by inertia, assessing future opportunities for growth whilst not neglecting current performance:
- Horizon one: current business focus
- Horizon two: emerging, identified opportunities
- Horizon three: strategic ideas to be developed
4. Set and hit your (proper) metrics Facts, transparency, and evidence have to be delivered to prove you are on the road to deliver the dream. The hype of unicorns superseded numbers, it was accounting jujitsu at its finest. At some point, startup gestalt of overpromise and underdeliver can paint founders into a corner where they begin massaging numbers. We’ve seen this in the tech startup darlings which I’ve referenced above and have crashed and burned. Most unicorns are losing money, make profit seems to be passe. Don’t ignore your cash burn as ‘all startups lose money’, show a dashboard of KPIs and a plan to get to monthly cash breakeven.
Raising capital isn’t a cure-all. Series A hubris isn’t innovation celebration, yet many rely upon a ‘get big fast’ growth model, financed though several rounds of investment, and with that, an almost compulsive need to spend cash faster which in turn drives up valuations. Unicorns are a neologism for market disruption. Maybe the next period will be more cautious, and we should expect future demand-supply of startup capital to be fairer, more sustainable and definitely more inclusive. The current zeitgeist is terrible for entrepreneurship generally.
5. Know the risks in your business model Your strategy is not to wish and dream of becoming a big fish too quickly, initially pick a small pond, engage with the smallest viable audience, and gain the reputation and trust you need to move to bigger audiences. Hold a big vision but take baby steps. Remember that doing something trumps doing nothing. Don’t be paralysed by an inability to figure out what you want to do, and being so afraid of taking the wrong decision that the opportunity goes by and you’re still working on stuff that doesn’t matter.
Manage your risks by finding as many downsides to an idea as possible. Avoid being the giddy optimist. Maintain a glass-half-full perspective, but work hard at uncovering possible hidden warts and limit possible losses before moving forward.
6. Have a vision and purpose, but don’t hallucinate The startup world is filled with the idolatry of winners, constantly promoted on Instagram, creating a frenzy that many then chase. The spoils, coupled with the false narrative that we live in a meritocracy, have dulled our sense of reality. We’re kidding everyone, and worse still, we’re lying to ourselves. We’ve lost sight of what’s important. We’ve lost ourselves. We’re addicted to growth at all costs. I’ve always preferred opportunities where time is an ally, not an enemy.
Now is the time to focus on the fundamental drivers and metrics, and adopt a common sense approach to fund raising, highlighting your value creation potential and your ability to mitigate risks. This paradox exists because investors need guidance on shaping their expectations for future performance. As the Red Queen said in Lewis Carroll’s Through the Looking Glass, it may take all the running you can do just to stay in the same place.
7. Be an agile leader The vacuum of strategic leadership in startups has undermined the fragile startup culture that investors tolerate and accept. If untruths become your strategy, you’ll be buried under them. In the case of Theranos it resulted in a calculated and deliberate fraud. Mindset drives behaviour, behaviour drives culture, culture drives business outcomes.
You may think you have the best thing in your venture since the advent of sliced bread, but stop drinking too much Silicon Valley loopy juice and lead your venture with clarity of purpose. Securing investment on acceptable terms is an indicator of the ‘wisdom of the crowd’, a signal of the investment community’s perception of your startup’s future growth and profitability, and whilst the leverage of investors will see them think they have the upper hand, if you’ve a scalable, robust, grounded business model, you’ll get funding.
And isn’t that the point? Once you have gained a better understanding of the bar you are expected to clear, you can turn your attention to meeting and exceeding those expectations. Remember the bigger picture. Funding today gives you the resources to build value, without it, you may not have that opportunity. Stick within the accepted boundaries and expect the same from your investor. If they’re trying to bully you with a depressed valuation, challenge them.
The shift in Klarna’s valuation is entirely due to investors suddenly voting in the opposite manner to the way they voted for the past few years, now questioning the truth worth of many tech business. But this can only be a good thing. First, it will level the competitive playing field, tech companies were using high valuations to build unsustainable businesses. They were rewarded for high-flying, yet unproven, strategies and questionable decision-making whilst rational market rules were being distorted. Solid but unexciting businesses were seen as ‘boring’ because they didn’t have a x25 revenue growth plan and missed out on investment. A correction will most certainly reduce this inequity.
Secondly, valuations will fall back and calm. Uber is a great company, but there was no rational way to justify its valuation of $60bn. Today, it’s $42bn. Snapchat has 330m active users, but it is hard to justify a valuation of $23bn for a company which posted $360m losses in Q1 2022 . With no visible path to profit, surely this isn’t sustainable?
Third, the flow of talent to the FAANG giants will slow and the tech salary inflation of 50%+ seen in 2021 will halt. This will enable tech startups with strong fundamentals and sensible strategies that have been seeing an exodus of tech talent and have struggled to attract new folks fight back.
So don’t ignore the reality of what we see unfolding, but equally don’t sit back and let the tidal wave of pessimism wash over you. Now is the time for high-growth tech startup to prepare. The unicorns have shown themselves to be unsustainable, but they are pointing the way to vacancies in investors’ portfolios. These opportunities will be auctioned and rationed, but as Marc Andreessen said in 2011, ‘software is eating the world’, and the digitisation of the economy is not going away; a correction in the funding markets will only make high-growth smaller tech startups more attractive.
In the long run, the big bets of the last two years lead to huge but unsustainable valuations and an emperor’s new clothes scenario. Now’s the time to get sharp elbows and get yourself noticed, but with a more grounded approach.