Startup Valuation Decline: Founder Preparation

The Startup Landscape Following the COVID-19 Pandemic

The declaration of the COVID-19 outbreak as a global health emergency by the World Health Organization in late January 2020 prompted a period of uncertainty within the startup community.

Numerous entrepreneurs anticipated a decrease in available funding and consequently paused recruitment and expansion strategies.

These founders focused on identifying methods to sustain operations in a world fundamentally altered by the pandemic.

Investor Response and Funding Trends

Reports from TechCrunch and other technology news sources detailed investors leaving Silicon Valley.

They began evaluating potential investments remotely, establishing temporary bases in cities like Austin and Miami to observe the evolving circumstances.

Contrary to initial expectations, the pandemic did not diminish investor enthusiasm.

In fact, the previous year witnessed unprecedented levels of VC funding, the emergence of numerous unicorns, and, in certain instances, a reduction in the thoroughness of due diligence processes.

Shifting Investor Priorities

Capital remains accessible to founders who demonstrate compelling narratives and present ideas aligned with current market needs.

However, investors are now placing greater emphasis on demonstrable revenue generation and growth metrics.

This shift in focus may restrict the types of startups that successfully secure funding.

Preparing for Market Adjustments

A key question being addressed is how founders should position themselves for an anticipated correction in startup valuations and a potential decline in investor activity.

Natasha Mascarenhas, Mary Ann Azevedo, and Alex Wilhelm, the team behind the Equity podcast, have offered their insights on the future of startup funding and due diligence in 2022.

Their predictions are detailed in this article: https://techcrunch.com/2022/01/26/is-todays-market-sad-or-sane/

Key takeaways include the need for startups to prioritize profitability and sustainable growth in the face of evolving investor expectations.

Natasha Mascarenhas: A Reassessment of ‘The Lean Startup’

Initially, considering the current economic climate, it seemed logical that private startups would prioritize extending their financial runway. This anticipation stemmed from the expectation of a corresponding deceleration in venture capital funding. However, as previously noted, a scarcity of venture capital isn't the prevailing condition.

The substantial capital held by mega-funds necessitates investment, suggesting that early and mid-stage companies may benefit from a more favorable funding landscape for a period. This could create a localized bubble within a larger market correction.

Is it overly optimistic to anticipate startups adopting more streamlined, cost-conscious operations, particularly given the current emphasis on growth and the prevalence of high valuations and readily available capital?

It is likely that a market downturn will catalyze a resurgence of lean startups. These companies will demonstrate an ability to maximize resource utilization. Eric Ries’ “The Lean Startup,” originally published in response to the 2008 financial crisis, championed a simultaneous approach to testing, building, and managing a startup.

The core principle involved prioritizing minimum viable products (MVPs) over fully developed platforms, fostering organizations that are both faster and more adaptable.

However, “The Lean Startup” now carries a caveat. Mega-funds have invested in companies that require substantial returns, placing pressure on their founders. Venture-backed founders must explore innovative strategies for resource allocation and iteration.

Opportunities abound, including leveraging contractors, part-time executives, and asynchronous work arrangements to moderate hiring or redefine conventional notions of “impact.” The prevailing terminology may also shift.

Rather than striving to become the “Amazon of X,” founders might concentrate on developing core competencies that enhance their resilience during a more significant economic slowdown. Furthermore, contingency plans, if not already documented, must be formalized.

Increased Focus for Private Companies

In the coming months, founders of private companies will likely need to intensify their focus. This aligns with the fundamental principles of efficient operation.

The pandemic introduced unprecedented volatility, exemplified by the rapid user growth experienced by many edtech companies as parents and schools adapted to remote learning.

These founders honed their ability to iterate rapidly in response to disruption. Now, volatility is being re-examined, though manifesting in different ways than consistent upward trends.

A Realistic Reset

Adopting a lean and agile mindset doesn’t signify a lack of ambition or stagnation. Instead, this recalibration appears sensible and grounded in reality.

Alex Wilhelm: Prioritizing Financial Stability

The assertion by Nas that “money over bullshit” resonates strongly as a guiding principle for contemporary startups.

To elaborate on the artist’s sentiment, startups should prioritize capital preservation to maximize their operational flexibility and longevity. For companies that secured funding based on optimistic projections rather than established performance, a prudent approach involves viewing current funds as potentially the last significant influx, at least until they achieve alignment between Annual Recurring Revenue (ARR) and valuation – a goal increasingly challenging to reach as public market revenue multiples diminish.

Currently, startups are navigating a challenging valuation environment, and their strategies should reflect this reality.

What practical steps can be taken? A slight recalibration, reducing emphasis on rapid growth and increasing focus on profitability, may be beneficial. As investor risk tolerance decreases, demonstrating the potential for long-term, positive cash flow and self-sufficiency will likely enhance a company’s ability to secure further investment.

However, simply reducing expenditure isn't the complete solution. The current market conditions present an opportune moment for startups to concentrate on a select few key performance indicators (KPIs) and disregard extraneous metrics.

The example of Brex launching a restaurant serves as a cautionary tale; it was an unconventional and ultimately distracting endeavor. Many startups are engaged in similar, less visible projects that divert resources. Any initiative that doesn’t directly contribute to ARR or other high-margin revenue streams should be critically evaluated and potentially discontinued. A period of focused decision-making is now essential.

Essentially, the principle remains: money over bullshit. Whether the present market correction represents a simple deflation of inflated valuations or the bursting of a speculative bubble is immaterial for startups capable of generating robust revenues and maintaining financial viability. The coming months will reveal which companies emerge from these market shifts with healthy balance sheets and a stable workforce.

Mary Ann Azevedo: Focusing on Core Strengths is Key

Concerns regarding a potential market bubble have been voiced amidst the recent surge in funding activity. Given the current downturn in public markets, investors should adopt a more selective strategy when allocating capital. Numerous startups are securing substantial funding even in the absence of a proven product, established customer base, or market entry.

A return to a system where companies demonstrate significant progress before securing large investment rounds is warranted. This includes demonstrable innovation, strong customer engagement, and substantial revenue improvements. Favorable unit economics should be prioritized over rapid expansion of personnel or ambitious growth projections.

Fintech companies, specifically, experienced considerable growth due to the increased adoption of digital payment methods and contactless transactions. This acceleration resulted in a faster creation of unicorn companies and expedited product development timelines, consequently driving increased recruitment efforts.

Investors readily provided funding, anticipating the emergence of the next groundbreaking venture. Startups experiencing impressive customer acquisition and exceeding growth targets frequently received preemptive and oversubscribed funding rounds. Many founders reported having to decline investment offers.

However, a more deliberate and cautious approach is now necessary, rather than attempting to encompass a wide range of offerings.

It is more advantageous to excel in a limited number of areas than to achieve mediocrity across many. Certain companies, particularly within the fintech sector, operate under the assumption that success in one domain automatically translates to others, fostering a relentless pursuit of growth at any cost.

As colleagues have pointed out, a shift towards profitability is crucial, moving away from the pursuit of ambitious objectives fueled by excessive hiring and wasteful expenditure. Consider Root, an insurtech company, which recently reduced its workforce by 330 employees. The company went public in October 2020 but has yet to achieve profitability and continues to face challenges.

Conversely, Creditas, a Brazilian fintech, is demonstrating impressive revenue growth. While not currently profitable, it is not hastily seeking an exit strategy.

Today’s startups should heed this lesson: a measured pace and consistent progress are more likely to yield long-term success.