Everything has slowed down in startup funding. There are more founders seeking cash, but fewer active investors. Investors are sticking their focus on their existing portfolios or sitting on their hands, intentionally doing nothing regarding new opportunities. A risk for founders right now is taking a lot of meetings with investors that aren’t actually investing. Last week I got a view from a VC: You have to talk with 3x more VCs to raise 1/2 the round at 1/2 the valuation.
The effects of the speculative explosion in startup tech after years of exaggerated valuations sees the market is adjusting, making it more difficult to raise money. Businesses that raised on inflated valuations during the bubble, swimming in all that venture money, will be the hardest hit. If you joined the startup scene before the pandemic, your perception of what is typical can be distorted.
It’s finding growth funding amidst uncertainty. Life sciences and healthcare remain strong, whilst multiples for fintech SaaS have come down considerably. AI/ML are no longer acronyms in a deck, they are very real now, and the only tech flavour where investors are looking to jump in. You may see high valuations here, but it is an isolated pocket, and the rest of the market is now more rational.
It seemed as if the age of readily available startup funding and cheap money would never end. Enabling business borrowing and domestic mortgage funding alike, the Bank of England’s base interest rate was set at 0.5% following the calamity of the 2008 financial crisis. It held below 1% until 2021. Then a succession of economic shocks arising from Brexit, Covid and more recently Ukraine, brought back the spectre of inflation, and the sentiment changed markedly. But after a series of increments, today we have a base rate of 5%, a level not seen since October 2008.
The last decade saw ultra-low interest rates sustaining a form of zombie capitalism and created an illusion of prosperity. But this is rapidly unravelling. For thirteen years the financial sedation continued, the country became more unequal, the economic pain now is the pain of sobriety, and recession lurks after a decade-long binge on cheap money. We may blame Andrew Bailey, Governor of the Bank of England, for administering the necessary bucket of cold water, but we should recognise that we drank expensive cocktails via Quantitative Easing, supported by successive Tory Governments, that brought us here.
So, it’s been a remarkably high-then-low 18 months for startup funding. The latest British Bank Report released last month made for some stark reading:
- For the startup equity finance market, investment activity has slowed considerably since Q3 2022. Investors have re-evaluated their positions, leading to smaller deals and lower valuations. Startup equity finance saw a turning point midway through 2022 following two years of very strong growth.
- Requests for funding have changed from seeking to drive growth, to supporting a business through inflationary pressures. Gross bank lending increased by 12.8% in 2022, however net lending fell by £8.5Bn in large part reflecting repayment of Covid loans.
- The success rates for those seeking funding fell sharply from 80% to 64% year on year. Q1 2022 was the end of a long bull run resulting in an ever-snowballing amount of exuberance as more and more investors wanted to be in technology, thinking the good times would be here forever.
Startups were raising money at crazy valuations and doing so way, way ahead of the proof points you’d expect in terms of progress. There were all sorts of things going on that weren’t particularly healthy such as deals being done with very limited due diligence, which is never going to end well. We had the Theranos and FTX debacles that moved from unicorns to undercorns, and the WeWorks and SoftBank farce, causing a massive swing in terms of sentiment and the deployment of new capital. There was a lot of capital that was transitory, coming due to the excitement in the market that has gone away but that’s probably not a bad thing.
Times have changed. Many investors have reconfigured their approach toward how well a company’s technology is progressing and which milestones they’ve hit, raising the bar on the amount of derisking that’s palatable to them. They’re asking themselves if the startup will hit enough meaningful milestones with the current raise to justify a valuation step-up at the next raise.
The trick for founders is to figure out which milestones are appropriate at a given stage of development from a technical, customer and financial perspective to attract investors. Measuring milestones ultimately depends on each company’s unique circumstances and each investor’s strategy. The ideal milestones provide a value inflection, which allows the company to raise their next round at a step-up in valuation. This is important from an investor’s perspective because cash flow can be negative for so long.
Against this backdrop, what approach should a founder seeking funding take? Let’s look at the thinking of a stellar investor – Charlie Munger, and what he looks for in an investible leader, and a hugely successful entrepreneur – Peter Thiel, and his perspective on what questions a startup venture must be able to answer to secure funding. What insights and learnings can we take from their philosophies, sitting either side of the funding table?
Charlie Munger
Charlie Munger is an American investor and philanthropist, vice chairman of Berkshire Hathaway, the investment vehicle of Warren Buffet. Buffett describes Munger as his closest partner and right-hand man. Munger looks at how a company has progressed, and its future strategy. He investigates thoroughly and acts deliberately – and infrequently. Once he has invested, he is loath to sell.
Poor Charlie’s Almanack is a collection of notes and essays from Munger. Here are ten lessons I learned from it regarding what he looks for in an investible business leader.
1. Be an independent thinker
Trying to be consistently not stupid, instead of trying to be very intelligent. In a world where we’re bombarded with information and different points of view, it’s important to think for yourself. Munger urges us to do our own research, think independently, and question everything.
What is really happening, not what you want to believe is happening. Recognising the truth is often painful, it may go against your prior beliefs or desires, but recognising reality is better than deluding yourself. You should readily change your mind. Be willing to destroy your favourite ideas.
2. Be rational: make informed decisions
Building on the first point, Munger advises us to avoid following ideas blindly without understanding the pros and cons. Practice divergent and contrary thinking. Invert, always invert is one of Munger’s key approaches. Many problems are best solved only when addressed backwards. Instead of thinking about how something can succeed, think about how it can fail. What can go wrong that I haven’t seen?
3. Have a focus
Being smart is not enough. Munger knows that you need to focus on the things that matter most. He’s also an advocate of ‘know your circle of competency’ – avoid doing stuff that is not in your zone of genius. Don’t pretend, and don’t bluff.
4. Use mental models
Munger emphasises the importance of having a latticework of mental models. In other words, you need to have a deep understanding of the major concepts in all areas of business life, not just a few. To become the most versatile problem solver, he believes that by having this foundation of knowledge, you’ll be able to make better decisions.
5. The dangers of overconfidence
To a man with a hammer, everything looks like a nail. Munger knows that overconfidence is dangerous. He says that when you’re overconfident, you tend to see things in black and white and more likely to make mistakes. It’s important to always question your assumptions, otherwise, you may find yourself making bad decisions because you’re confident that you’re right when you’re not.
6. Humility
It is astonishing how much long-term advantage people like us have gotten by trying consistently not to be arrogant. Munger believes that humility is a crucial character trait of business leaders, being humble is more likely to be successful in the long run because they’re not arrogant, which leads to blindly making mistakes.
7. Thinking like a multiplier
Munger urges thinking like ‘multipliers’ rather than ‘addition thinkers’, in other words, don’t just focus on one thing, try to find ways to apply your innovation to multiple areas of your business. He counsels businesses to widen their moats every year. This doesn’t necessarily mean earning more profits each year, but rather growing a strategic position for the long term.
8. The importance of reading
I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do. Munger is a voracious reader, reading 500 pages per day, and believes reading is essential for success in that you’ll be better informed to make decisions based on learning, logic, and reason, not emotion.
9. Avoid herd thinking
The habit of herd thinking, following the crowd, leads to groupthink, where you’re more likely to miss opportunities because you’re blindly following the masses. It’s important to think for yourself and question the status quo to stand out from the crowd.
10. Be patient – but decisive
The big win is not in the buying or the selling, but in the waiting. Patience allows you to make calm and rational decisions, rather than impulsive ones. Munger’s approach is to be inactive when he doesn’t see opportunity. However, when he sees one, he moves quickly and bets big.
Peter Thiel
Peter Thiel was a co-founder of PayPal, Palantir and the first investor in Facebook. He is a co-founder of the Founders Fund, among its investments are Stripe and SpaceX, two of the most valuable tech ventures today. Thiel authored a great book, Zero to One, in which he shows how we can find ways to create new things. This insight for founders should be in your everyday thinking:
Doing what someone else already knows how to do takes the world from 1 to n, adding more of something familiar. But when you do something new, you go from 0 to 1.Tomorrow’s champions will not win by competing in today’s marketplace. They will escape competition because their businesses will be unique. It starts by learning to ask the questions that lead you to find value in unexpected places.
My takeaways from Thiel are the following key questions:
- The vision question Are you just jumping on a bandwagon or reshaping an industry’s future?
- The engineering question Can you create breakthrough technology?
- The timing question Is now the right time to start?
- The monopoly question Are you starting with a big share of a small market?
- The people question Do you have the right team?
- The distribution question Do you have a way to deliver your product?
- The durability question Will your market position be defensible for long-term success?
- The secret question Have you identified a unique opportunity that others don’t see?
Take note of Munger and Thiel’s perspectives, as for the foreseeable future startup capital will be scarce. With a foggy economic outlook, yesterday’s fundraising playbook might not cut it – you must show a clear ‘path to profitability’ to get on investors’ radars.
Currently, the thinking of most investors isn’t aligned with early-stage founders. Investors are spoiled for choice, increasingly seeking founders with early traction/revenue. Not all startups are up to scratch, founders with just an idea and a dream seeking funding to get initial traction or to weather macro-economic challenges will struggle. There is very little appetite for that kind of deal.
There’s no easy answer to this out-of-sync dynamic, but it makes life harder for founders. Early revenue from a small but impressive roster of clients, strong sales pipeline – or AI driven tech to scale and differentiate growth inflexion – is the way to get noticed.
