There has been a noticeable shift in sentiment within the venture capital community, with a greater emphasis placed on prudence and due diligence when it comes to investment decisions. The tech industry has been particularly affected, experiencing widespread reductions in valuations and significant staff cuts. In light of this, startups looking to raise capital may face a more challenging landscape in the near future.
It’s important to recognize that the current situation is the result of an excessive degree of speculation that has persisted for an extended period. As a result, the market is undergoing a correction that may make fundraising more difficult. However, for companies that are still in the seed or pre-seed stage, the impact may be less significant. Those that grew too rapidly during the period of inflated valuations will likely be the most affected.
Despite the current challenges, it’s crucial to remain focused on core business principles and maintain a long-term perspective. Our advice for fundraising in this environment is not substantially different from our prior recommendations. A steadfast commitment to fundamental business practices and a clear vision for the future will help startups navigate this period of turbulence. Please refer to the following section for specific strategies and guidance.
We’ve Been in a Funding Frenzy
For those who joined the startup scene around 2018, their perception of normalcy may be somewhat skewed. Investors have been pouring vast sums of money into startups in recent years, which may have created an unrealistic view of what constitutes a typical valuation cap for a pre-seed tech startup. In reality, the norm is typically in the range of 1-3 million dollars, assuming the company has a compelling concept and is targeting a significant market.
However, in 2021, we saw pre-seed companies receiving valuations of 10-15 million dollars, with a few particularly extreme cases even reaching 20 or 30 million dollars. It’s important to note that we’re talking about startups that hadn’t yet created any products or generated any revenue.
So how did venture capitalists justify making such high-risk bets on unproven companies? Essentially, it was because everyone else was doing it. In the past few years, startup valuations were rising at an unsustainable rate, fueled by market speculation. Investors could be confident that even if a company failed, it would likely receive a higher valuation in its subsequent funding rounds. Additionally, the strong economy at the time further fueled this trend.
In other words, the past few years of the VC market have been one big orgy of market speculation. That pushed startup valuations way higher than their financials warranted.
Not anymore.. Startup Funding is Drying Up
But in the past few months, a few big shifts have made VCs much less confident. There’s rising inflation. Supply chain issues keep getting worse. And Russia’s invasion of Ukraine has thrown a ton of uncertainty into the global energy market. All of a sudden, a huge speculative investment in a pre-revenue company doesn’t seem like such a safe bet.
So the capital is drying up. That’s bad news for the startups that were swimming in all that investment money. If they want to raise money, they have to settle for a down round at a much lower valuation. And that sends a very bad signal to other investors. Sometimes it can trigger a race to the bottom that completely tanks the stock price.
A common alternative is for investors to put heavy conditions on their next funding round. They’ll tell founders that they have to meet robust profitability targets to keep their high valuations.
That’s a tough ask for startups that have spent years pursuing growth while putting off revenue. Often, they can only meet those targets by cutting costs. That usually means layoffs. So if you wondered why the past month has been such a bloodbath for tech jobs…now you know.
There’s an element of unfairness in all this. In many cases, investors were pushing these companies to ignore revenue and chase growth at all costs. Now they’re turning around and asking for financial responsibility. So startups and tech workers get punished for the VC’s wild bets. Unfortunately, that’s often the reality of the market.
Funding For New Startups?
We’ve just painted a pretty bleak picture. However, you’ll notice we were talking about the startups that got huge by guzzling all that easy money. If you have a small startup in the seed or pre-seed phase, you don’t need to worry as much.
That’s partly because you don’t have as far to fall. If you’re not funded yet, you don’t have to scramble to keep your runway. And if you’re not pegged to a crazy over-valuation, you don’t have to be concerned about a down round.
If anything, smaller companies that aren’t seeking huge valuations look much better to investors right now. Your stock price hasn’t been driven up by a five-year speculative bidding war.
Data and Numbers Are Your Friends
The moral of this story is to anchor your fundraising goals with data. Don’t try to shoot for the highest valuation you can get. And always have a roadmap to profitability. You can’t count on investor cash to keep you afloat while you grow.
This is why we emphasize validating your business model in the marketplace before going to VCs. Buy some ads or make some cold calls. Figure out how to get your sales costs lower than your customer lifetime value. Then look for startup funding to help you scale up.
What if you really can’t build your product without some venture capital? In that case, set your valuation based on what you need, not how much you think you can get. Calculate what it will cost to get your company off the ground, then negotiate for a valuation that gets you that amount.
Play the Long Game
The capital market looks intimidating right now. But one crucial takeaway from this post is: don’t focus so much on market fluctuations. Yes, you need to adapt to economic conditions as they shift. However, when you’re thinking about what your company is worth, think long-term.
If all goes well, you’ll probably be running your startup for at least the next 5-10 years. The market is going to go through some fluctuations in that time. It’s inevitable. In fact, this exact cycle of inflating valuations followed by a crunch will probably happen again in another decade or so.
That’s why you should plan based on hard numbers like customer acquisition cost and lifetime value. If you count on the market to keep doing what it’s doing, it will disappoint you sooner or later.
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The Bottom Line
Capital is going to be tighter for at least the next year or two, and maybe longer. That shouldn’t intimidate you if you’re still running a young, scrappy startup. And it shouldn’t change your basic strategy. Get your fundamentals right before you go chasing capital.
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