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It started with word spreading through Silicon Valley last fall into winter about the term sheets for start-up funding getting pulled.
Now, a less frothy Silicon Valley is the assumption in beginning to understand the outlook in a world of rising interest rates and declining market liquidity, and investors who are no longer willing to fund profitless futures indefinitely.
But how exactly will the venture world of the past decade – with record levels of fundraises and valuations fueled by massive market liquidity – begin to change?
The entry point for the discussion is as much about the massive influx of liquidity that private companies experienced in recent times as the sudden decline in liquidity taking place now. Many start-ups have a lot of money left on the balance sheet after mega rounds in the past year. In 2021, VC funding was $620 billion, which was more than double the previous year. Prior to 2021, the market was averaging 150 unicorn births a year – start-ups valued at $1 billion or more. There were more than that number created every quarter last year, and companies were being funded as unicorns earlier than ever, with 25 companies reaching the valuation between Series A and C rounds, according to CB Insights.
“2021 was a strange year, because so much was going on. There was a little bit of FOMO,” said Brian Lee, senior analyst, enterprise technology at CB Insights.
“We stopped calling it a record year for venture capital in 2021 because it didn’t even do justice to what was going on,” said Kyle Stanford, senior VC analyst at PitchBook.
A few recent examples from the 2022 CNBC Disruptor 50 list: No. 1 company Flexport, which raised a $900 million round of capital in February as it seeks to capitalize on technology to remake the broken supply chain; low-code software company Airtable, ranked No. 33 this year, raised a $735 million round last December that doubled its all-time funding level.
But many Covid winners, similar to what’s taken place in the public stock market, are experiencing a mean reversion in growth rates. Year-over-year fundamentals don’t look great, even if many still have good longer-term business models. And cash will burn quickly, with start-ups flush with cash for another six to nine months. After that, for many companies, the math will become tougher to make work and the runway will run out before they have the opportunity to grow into the rich valuations of the recent past.
“So much of the growth over the past five years has been, ‘We will give you more money than you want or need but you better grow as fast as you can and make sure any competitors in your space are burning even more than you … and if you do that, we will give you even more money,'” Stanford said.
Start-ups were growing in a cloud-based world with less capital required for growth and the ability to operate with no hard assets. “Growth is basically what they can do to differentiate themselves and there’s been so much capital from VCs and hedge funds and MFs. That’s how companies have looked to differentiate. It’s take market share and worry about the profit later, and I guess now is later,” he added.
The financing options aren’t great. Investors will be seeking much better terms across fewer deals. Softbank CEO Masayoshi Son, synonymous with the era of big bets on start-ups pushing them to unicorn valuations, said last week it may reduce investments by up to 50%.
There’s talk of a lot of “dry powder” remaining in the venture market, but crossover funds like Tiger Global, which invest in both public and private market companies, have seen valuations on the public side go down significantly, throwing their public versus private portfolio weightings out of whack. This implies it could be a long time before they are again net buyers of venture capital. The large pool of public capital, including mutual fund companies like Fidelity Investments, might not be as active in the private market, completing the retrenchment among investors after years in which the competition to access deals was so intense that protections once offered to VCs and peers in deals were being given up.
“We’ve heard from lots of growth stage investors that they are much more cautious and skeptical of deals,” Stanford said. Even strong revenue growth will not equate to the multiple afforded to revenue growth last year. “They are looking at a down round,” he said.
One way to avoid the down round is for companies to give up more in terms of investor protections built into deals. Competition had been so intense for deals, investors were dropping protective terms, owning larger stakes in companies and more shares to make their investment whole in an eventual exit. “If they come back in full force it should help keep valuations high, rather than take a down round which has signal risk to future investors.”
One example of better terms in equity deals is participation rights in preferred shares that give investors “double dip” proceeds at time of exit, a punitive way to raise capital, with significant dilution to founders and employees with stock.
Credit markets are not favorable for new issuers, especially companies whose business models seem tenuous. Recent deals in the public market like Carvana tapping private equity giant Apollo to rescue a junk bond deal show how expensive it will be to rely on non-traditional lenders.
Given this environment, more companies will be looking to raise convertible notes once their cash is low rather than pursue primary equity financing to make the best of a bad world when it comes to valuation – avoid a down round if only eking out a slightly higher valuation. While those in the know, know, the convertibles give the appearance that the nominal equity value in the fundraising is going higher.
“While many unicorns are still sitting on massive war chests, many others will need capital and face the prospect of a down-round due to the valuation reset alone,” said Matthew Kennedy, senior IPO market strategist at Renaissance Capital, which is a provider of pre-IPO research and two IPO-focused ETFs. “Companies also face slowing growth as [sales and marketing] budgets get tighter, if not from weaker fundamentals during a potential recession. Companies without a viable path to profitability may be sold or shut down,” he said.
One example, checkout technology Fast, which had among its recent lead investors, fintech giant Stripe, No. 8 on this year’s Disruptor 50 list.
“For years, entrepreneurs have been in the driver’s seat — we expect that to become the exception, rather than the rule, in the new environment,” Kennedy said.
Some of this was predictable, and as far as the ways the markets work, also cyclical.
“Valuation has always been part art and part science, and when you’re in markets where there is lots of optimism and exuberance, more emphasis is placed on what the future will look like rather than what is happening now,” Lee said. “Now it’s lots of conversations about getting back to fundamentals and valuations will incorporate more elements to show companies can survive on their own, profits and free cash flow. “
He says this means more flight to quality at the late-stage end of the VC-funded market, but for early-stage companies, where revenue is hard to come by as a rule, and investors will continue to give them more latitude. And he isn’t convinced a recalibration means the world is ending. “The next year, or next five years, will look like a rollback to a more reasonable valuation, but not a precipitous decline to 2010,” Lee said.
For start-ups facing the new reality, a good place to start to reevaluate is in their growth rate. The new view of growth is not at all costs, but growth at a reasonable cost. Advertising and marketing spend are going down, as well as headcount, and a lot of other discretionary areas of spending tied to growth are ones that start-ups will pull back on as they seek to conserve runway. It’s already taking place among the former top disruptors now in the public market, led by Uber.
This shift in the public market hits the highest value private start-ups first, the ones whose IPO deals are theoretically closest in time. The public market peer for these pre-IPO companies is now the comparable valuation statistic, not the average, huge late-stage valuation from recent years.
Some companies, such as Instacart, have proactively lowered their own valuation, but not many yet, a sign of just how painful that decision is for founders, though it can be the right move to keep attracting top talent in the tech sector, where stock options are crucial to compensation, a factor that Brex, the No. 2 Disruptor this year, alluded to in talking about a tender offer it completed for employee stock.
Instacart’s sector of online grocery is a good example of the shakeout that is occurring in real time, as investors over-wagered on the share shift that took place between e-commerce and grocery sales during the pandemic becoming permanent. Instacart’s business plans didn’t revolve around a forecast of growth being flat or down. This miscalculation will force companies to make cuts in more than valuation: across spending, such as in sales and marketing, as VCs wait to see signs of a path to profitability, and potentially still push these start-ups to come back to market at a lower valuation.
Another highly funded start-up in the on-demand grocery sector, Gopuff, raised a primary equity round during the summer 2021 which valued it at $15 billion, though a more recent convertible offering in December had a valuation cap — the maximum valuation at which the investment made via a convertible note can convert into equity — at $40 billion.
For start-ups Series C and onward, looking at the IPO exit within the next two to four years, there is no doubt investors will care a lot more about profitability than they did before, maybe not “today,” but these companies do need to be in a better position to show a clear path to profitability sooner than five years.
How tech workers and their paper stock riches get hit
This reset will have implications for the war over talent in the Valley as start-ups facing valuation declines navigate two distinct groups of employees. From a messaging perspective to existing employees, preemptively cutting valuation by a significant amount or going back to the VC market at a lower valuation, is a tough message to send. Telling existing employees the company is worth 50% less is a tough message.
But to attract new employees, start-ups need to issue equity at a price that is fair market value. That’s a tension that start-ups with high valuations will be dealing with, and buying back shares from existing employees through tender offers is one method of stock-based retention at a time when an initial public offering may be farther off. Henrique Dubugras, CEO at Brex, ranked No. 2 on the 2022 CNBC Disruptor 50 list, said it has been buying back shares for employees to the tune of $250 million.
That’s a big change from an expected level of compensation gains that has suddenly been made unsustainable among a generation of companies that benefited from loose monetary policy which fueled market liquidity – and had not been through a crisis like the dotcom bubble or 2008. The job-hopping was even taking place at the high-flying unicorns closest to IPOs, where tech executives say you would expect the least turnover. Now employees may not bolt for younger rivals, with the ability of early-stage companies to compete using rapidly escalating equity mark-ups reduced. They may now be more likely to chart a flight to safety path to the largest, often already public, companies in the Valley. Though even there, the situation is tenuous, with companies as big as Meta Platforms and Netflix both signaling a change in rapid hiring. Uber’s CEO said its new more conservative approach will treat hiring as a “privilege.”
A generation of founders unfamiliar with profits
Recruitment and retention is just one wrinkle in the bigger question: Can founders change? Many start-up founders from the current generation and world of declining interest rates and cheap capital, still underappreciate the reversal in conditions and reduced money in the system as a decade of quantitative easing turns to quantitative tightening.
Don’t fight the Fed has been a Wall Street mantra for decades. When the paradigm in liquidity is changing in a sustained way, it should also change the way start-up founders and CEOs are managing their balance sheets. It takes an optimistic, risk-taking individual to be a business founder, but if this lesson hasn’t been internalized since last fall’s downturn began, the time is now, and no recent evidence should be invoked to say the worse is over.
Founders have been in a world for years that has only ever seen hiccups, like a six-month break in bullishness after WeWork’s IPO collapsed, and the brief Covid crash before a VC market that was better than ever before. This time, a longer-term recalibration is the most likely scenario.
Now the outlook for fundraising will focus on quality, it will be concentrated, and it will occur for companies that are already leaders – with the market share and revenue to back it up –
The Instacart valuation cut is also a sign of potential optimism. They’ve already taken the hit, removing one reason to worry about pricing below expectations. Six to nine months ahead, maybe the markets are better and the company has passed the big Covid growth re-baselining. Whether Instacart or another leader in a niche where there is opportunity, growth will start reaccelerating. But the market is simple when it comes to a non-starter for deals: it doesn’t want to own decelerating growth. No other numbers can cover for that, and stopping the growth numbers from going in the wrong direction could take into next year.
As Aaron Levie, founder and CEO of original CNBC Disruptor 50 List company Box, recently told CNBC, “I’ve literally come around to the other side of this thing, which is having a healthy balance of growth and profit is actually a really good thing.” Silicon Valley has its own cycles, and founders should always look at long-term economics, and “how you’re going to generate cash flow in the future, because that future might come faster than you think.”
“Who would have thought profits mattered?” Stanford said.
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Correction: Gopuff raised a primary equity round during the summer of 2021 which valued it at $15 billion. A more recent convertible offering in December had a valuation cap — the maximum valuation at which the investment made via a convertible note can convert into equity — of $40 billion.