Startup Markets, Summer 2022 Edition

Wednesday, July 6, 2022

Startup Markets, Summer 2022 Edition

About a month ago, I wrote a tweet storm on the changing startup financing and employment environment. This blog captures aspects of that tweet storm and some of its predictions and extends them further. Like all predictions this is what I view as a highly likely scenario versus the only potential future path for the next 3-18 months or so.

The high level view is that things have yet to get truly bad in private tech.  2021-2022 were an anomaly due to COVID policies which both created an incredibly cheap low interest money environment, pumped the stock market, and facilitated adoption of certain types of tech. This environment led to both excess in fundraising but also in hiring. This means that as money transitions back to to "normal" levels teams that were hired too far ahead need to shrink. Many areas (hiring plans, valuations, time venture capital raised lasts, etc) are roughly reseting to 2018/2019 norms, which themselves were all time highs prior to the COVID era.

If interest rates and money supply continue to tighten and a recession happens, then things should get worse. The below largely deals with the base case of things roughly stay where they are now. More likely, things will get worse before they get better. Nonetheless, it is still a great time to start a company.

So what do the next few quarters look like?

1. Financings

Valuations will continue to drop and are not stable yet

Private markets tend to lag adjustments in public markets by 3-9 months and tend to adjust from the later stage, pre-IPO companies first to the pre-seeds last. Private technology startup valuations are still unstable and for some stages will continue to drop. 

Series D and later have come down and closer to public comps with pre-IPO companies roughly at public comparables. When you fundraise matters a lot - rounds started 3-4 months ago are pricing much higher than rounds kicked off now. 

We are in a “sliding knife” market and things have only partially propagated into earlier and earlier companies. For example, series B/Cs have dropped 30-70% but the repricing is inconsistent. Some companies have been getting high valuations over the last few months while others can not fundraise at all. Series A valuations have dropped maybe 20-30% but likely should drop 50%+ from highs. 

Series seed rounds have come down some but will likely drop further as more series A reprice harder as investors seek each round to be 2-3X the valuation of the prior round (the traditional standard). Private tech is for some stages where public tech was towards the beginning of this year. 

Hitting a new startup market valuation stable point is likely to take another quarter or two barring a recession or additional public market drops. These things take some time to fully propagate to all stages, founders, and investors.

Top up rounds 

Many companies are doing quick top-up rounds to add 6-18 months of runway and ensure the company has 36 months of cash to outlast any economic downturns or recessions. These rounds may be anywhere from $1M to $30M in size. Valuations on top ups have increasingly gone from slightly up to flat with the prior round.

If you have supportive investors, doing a top up round may be wise simply to have more padding. You want to make sure you are either default alive or default fundable. The only downside of doing one now is investors are starting to get top-up fatigue as so many companies are doing these small bump rounds.

Metrics and speed

Investors are refocusing on metrics and actual diligence again before investing in companies. This means the time for each fundraise is stretching back to historical norms. While fundraises in 2017 took 2-4 months for most companies, during 2021 a round could happen in a few days to a few weeks.

Investors are looking for metrics around burn multiple & capital efficiency, net revenue retention, growth rate, and overall cash needs of the company.

As money leaves the market (see below), fundraises are likely to slow from 2021's a company raising a new round every 6-9 months back to the historical norms of a company raising a round every 12-24 months. Companies with a valuation that far exceeds their product/market fit may not raise for 24-36 months, and many of them have the cash to last that long.

Expect structured rounds or down rounds in the coming quarters

Down rounds and structured rounds (where investors are "guaranteed" certain payouts if the company survives) will likely accelerate in 6-18 months. They will largely impact companies that raised during the all time highs of Q3 or Q4 2021 and now find themselves "stuck" and unable to raise more money. These will accelerate as a number of companies get low on cash and need to raise again, but have failed to grow into their 2021 valuation.

Companies like Facebook, Square, and others have had to do down rounds or structured rounds at one point or another. So, it is not the end of the world if it happens.

Many unicorns will need to reprice if they can not get to high enough ARR with strong unit economics/burn multiple. Others will reprice for employee options.

Many unicorns have yet to realize they are stuck for now with too high a valuation and that they may never hit current levels again. Lots of “zombie” companies do not quite realize they are stuck yet and may never see their valuation highs again. Lots of companies will take 2-3 years until next round to catch up on Q4 2021 valuation.

Money leaving the market

Many investors who can invest in either public or private companies are mainly just focusing on public companies. This not only includes hedge funds, but also family offices and in some cases traditional venture funds. They view public markets as superior in terms of multiples and returns. Why invest in a $5B valuation private tech company with $50M in ARR when you can invest at a $5B valuation for a public company adding $50M in ARR every two months? Public companies are also liquid at most moments so you can exit the position more easily, and you can also hedge the position.

In parallel, venture capital LPs (the people who invest in VC funds) are asking traditional VCs to slow their investment pace. In 2021, VCs invested their venture funds in a single year. So a $1B fund was largely invested the year it was raised. Now LPs are asking VCs to go back to 2018 standards and invest over a 2-3 year period. So a $1B fund would get invested at a pace of $300M-$500M a year. Thus you decrease the actual VC dollars in the market by 2-3X, even if the fund size announcements sound the same.

Net-net is a number of sources of venture funding are out of market right now for the latest stage companies, pushing their valuations down. This will back propagate into earlier stages and will last as long as it takes to reset valuations across the board.

2. Employment & hiring

Layoffs are just beginning. Many companies are planning them now but have not pulled the trigger. For a bigger company it may take 1-2 months to decide to do a layoff, 1 month to plan it, and then a few days or weeks to do it. Smaller companies can move much faster, but represent a smaller proportion of the overall tech employee base. 

We will see more layoffs in the next 1-3 months and then again in 6-9 months. Many will not cut enough and will need to do a second layoff 6 months later. Others have not seen business drop or are not conserving cash. “We will grow our way out of it”. These sorts of companies may do layoffs 3-6 months from now when they realize their burn multiple is too high or their own revenue decelerates as their own customers cut costs. Some startups who sell to other startups may be most vulnerable in this regards in the short term.

Create a plan, don't just blindly cut

A minority of companies may cut when they shouldn't, as their business is doing great. Context matters. Create a revenue and burn plan versus just blindly cutting. Maybe you should take this opportunity to hire great talent that will have fewer places to go? Maybe you should invest in growth within burn multiples?

If you do have to do layoffs, it is usually better to err on the side of cutting deeper than is needed and then rehire later versus doing multiple layoffs spread out in time. While most cultures can sustain a single layoff, it is harder to do multiple in a row and this can negatively impact all the people still employed with the company, as well as employees who get laid off who thought they were safe. 

In general, it is easiest to a layoff when all your peer companies are doing layoffs. Your employees will view it as an industry-wide event versus something specific being an issue at your company. Obviously, you should only do a reduction-in-force if you truly need one. But all else being equal, timing wise it is both better to do it early (to conserve more cash) and when others are doing it (to minimize cultural impact and concerns about company health).

Some companies have also started getting more aggressive in performance cycles and letting go of 10% or so of their employees who are underperforming relative to their peers. In this case it is not a layoff but simply tightening performance criteria. GE famously would do this performance based approach annually, and McKinsey similarly had an "up or out" policy on an annual or every 2-4 year basis.

Cleaning up culture

Expect more “cleaning up mission and culture at work” moments. More CEOs will reemphasize that the company focus should be on customers, business building, and its core mission. In a turbo charged hiring market, the relationship power on average lies with employees over management. As markets normalize, lay offs happen, and jobs outside of MAMAA companies get sparser. Management regains some power and more importantly backbone. Maybe the vehement Slack debate on international political regimes that properly support organic oat milk[1] are at least partially superfluous for your pet insurance startup whose business is tanking?

MAMAA companies will continue to be the core of tech employment & compensation

Meta, Apple, Microsoft, Amazon, Alphabet (MAMAA companies) are a giant talent, compensation, and entitlement sink for the industry. They employee a significant portion of the overall tech employee base. For example, Facebook "only" plans to hire 7,000-8,000 new engineers in 2022 (currently at ~80,000 people). Google, Microsoft, and Facebook have around 400,000 employees between them. Apple is 370,000 people (but includes retail and other areas) and Amazon is over 1,000,000 (due to warehouses and other areas). Big tech employers are now a major part of the overall tech employee base and serve as a sink, buffer, or reserve for the industry in terms of layoffs, culture, or other areas.

Mergers and Acquisitions (M&A)

More M&A will happen. Founders are finally talking about selling when before there was little incentive to do so due to ever rising valuations and secondary stock sales.  In a tougher fundraising environment, M&A will become more of a buyers market. There should be lots of exits or attempts to exit in 6-18 months. Companies will realize their business is not that strong, or that exiting and having liquidity is better than trudging on indefinitely. As private market valuations align more with public market ones, it will also be easier for larger companies to justify buying smaller ones.

Recession

Recession (if it happens) likely to hit startups selling to other startups first, then startups selling to mid-market customers, then those selling to large enterprise. In parallel, companies that had a big positive COVID bump in revenue may now see a slow down as people return to offline activities and spending.

Recessions drop revenue and earnings growth which slows everything down for affected companies. If earnings and revenues drop so will growth rates and valuation multiples. For startups, a recession may slow their sales cycle and adoption as their customers cut costs.

If a recession happens there will be room for growth, multiples, and valuations to drop and for capital availability to tighten further. This may lead to further layoffs or other turbulence.

Even without a recession we may see a number of public technology companies miss their earnings in coming quarters as things slow, leading to a broader decline in the segment's multiples and market caps.

Building in this era

The reality is that relative to historical norms, we are not into truly tough times yet for the tech ecosystem. What we have seen is monetary policy tightening to combat inflation (which was caused by quantitative easing, money printing and drops to consumers by government as part of COVID policy, and some shorter term supply chain issues). The new quantitative tightening and removal of liquidity from the economy has caused the cost of capital to go up, and growth stocks to drop back to 2018-2019 levels - which themselves were all times high (This is of course an aggregate view. Some companies are undoubtedly being inappropriately penalized right now market cap wise, while others may still be far ahead norms). 

In other words, nothing truly terrible has happened in aggregate yet relative to 2018-2019. However, during the last two years the startup (and public markets) ecosystem ran ahead of itself on valuation, fundraising, and hiring. This overbuild means many companies need to slim back down to match their real revenue base, and many companies raised at a valuation that is high relative to their progress. A number of companies will inevitably grow into these valuations and be fine. Others will need to do down rounds, structured rounds, or exit to others.

It is possible with ongoing tightening of monetary policy (interest rate hikes and QT) that times will get worse. In that case you can expect further acceleration of layoffs and more valuation drops. Even if that were to happen, this is still one of the best eras in history in which to build a company. Capital and information are still broadly available, opportunities abound, and we are undergoing a generational shift to technology underlying all industries in a variety of ways.

A number of great companies will be built in this period. Apple, Microsoft started in 70s stagflation. Cisco started after “black Monday”. Multiple great companies emerged & grew post financial crisis (Uber, Airbnb, Stripe, Square etc). Nothing fundamental has shifted in terms of the long term view of technology as a transformative force remaking the world.

It is still a great time to build.

Notes

[1] Oat milk is quite odd in that unlike most other non plant-based milks which date as far back as the 13th century, oat milk was invented in the 1990s. Oat milk can also have a high canola oil content as the canola acts as an emulsifier to put the oats in suspension with the water. Oat milk was invented in Sweden, which makes intuitive sense on many levels. https://en.wikipedia.org/wiki/Oat_milk