Take a deep breath

After four months of market volatility, with half of the steep decline just in the last month, the conventional business wisdom has rapidly switched from exhilaration to one of doom and gloom. This is especially true in the tech economy and in startup land.

Here is the good news. When social sentiment is either extremely good or extremely bad, you can be certain that the truth falls short of the extreme. I am not the first to point out that social media and “professional” media channels magnify the already excitable human condition. A turning tide that exposes who is swimming naked also jars us into believing that the unlucky companies that now need to layoff employees and cut burn were doing amazingly well until the tide went out. Not so. Most of them have been swimming naked the whole time, or even walked naked to the beach!  

Burning too much capital to make too little progress is always a risk and symptomatic of an unhealthy startup, whether the market previously overlooked and rewarded perverse behavior with a financing round, or not. “The market” is not interested in doing that anymore.

The sugar high was wonderful. 2020 and 2021 were a once-in-a-generation opportunity for business model risk taking and liquidity, but now we’re back to the meat and potatoes of balanced cash burn and responsible growth. For the startups that bake this into their strategy, there is the added opportunity that talent markets will likely be more favorable in tech – and possibly beyond if there is a recession. This, after a ten-year run of tightening and then white-hot talent competition. It shouldn’t be lost on anyone that two of Chicago’s greatest growth stories of yore – Redbox and Grubhub – were built during weak labor markets of the financial crisis. In times of economic weakness, outsized resources and gains go to the victors.

I am also uncertain about the conventional wisdom that high interest rates will be terrible for the tech economy and startups. Yes, a high interest environment traditionally hampers companies and industries that require high levels of investment capital, because risk capital instead chases yield. That makes sense, but with very few pundits or operators ever having lived through a high interest rate paradigm (including me), it makes it easy to oversimplify (and to be naïve?).

As evidence of interest rate risks to tech, many point to crossover funds that funded the exuberant late-stage rounds of 2020 and 2021 now putting their pencils down in the private markets. Their reduced willingness to fund excessive pre-IPO pricing risk is just starting to reverberate down to mid and early-stage funding rounds. However there is a strong case that what we’re seeing makes sense after the pandemic and has little to do with interest rates. As Natasha Mascarenhas said for TechCrunch in “It’s not a startup reckoning, it’s a recorrection”:

Over the past two years, tech rightfully became more critical than ever for the services that it provided to the average human, whether it was empowering an entirely distributed workforce or helping us get access to health services via a screen. It also became vulnerable. Pandemic-era growth has always had a caveat: The tech companies that found product-market fit, and demand beyond their wildest dreams, are the same tech companies that knew their win was at least partially dependent on a rare, once-in-a-lifetime event that (hopefully) would go away one day.

While we’re still waiting for good 2022 private valuation data to form, public comps seem to support Natasha’s view. The BVP Nasdaq Emerging Cloud Index is a good public proxy (and canary in the coalmine) for where private market valuations may go. What we see is that public comps are normalizing to pre-pandemic trend lines…

EMCLOUD Index

BVP Nasdaq Emerging Cloud Index Performance

… and valuation multiples are back where we started.

EMCLOUD EV/Rev Valuation Multiples

BVP Nasdaq Emerging Cloud Index EV/Revenue

Of course, now is a moment in time, and trends may further deteriorate. Even if they do, my bet is that they rebound.

Apple, Google, Microsoft, Amazon and Intel hold more than $600B in cash. Google, Microsoft and Intel will keep acquiring (okay, Apple and Amazon do less of that) to maintain their moats, just as they’ve always done. The longer tail of tech giants like Salesforce, CISCO et al will too. The ultimate demand for new technology, business models and unique talent remains high.  

All of this is to say that things may not be as bad as they seem or what we hear. Nevertheless, plan for the worst; hope for the best! So we are coaching our teams:

  • Cash is king/queen: This isn’t a new refrain. Manage your burn and maintain runway. I love to see a SaaS business adding $1M in revenue for each $1M of cash burned – hard to do but easier if you burn less and grow a little slower. I also love seeing net burn below monthly revenue. So, if in a month you’re doing $100K in revenue and burning less than $100K that’s terrific. (Of course you also need to be growing to want to do that.) The days of burning $5M to get $1M in ARR or burning $500K in a month to produce $100K of revenue in that month are gone.
  • Manage your expectations: I met with an at-launch company last week and asked them how much they were raising. “5 on 35”. My response: “wuh?” As the market quickly shifts, it’s easy to lose track of the market or blow a conversation by being tone deaf. Consider that early-stage rounds will likely revert to the typical 20 to 30% dilution we used to see, and later stage rounds up to 20%+ from the 10% they fell to.
  • Beware the middling third: The top third of companies should continue to have funding opportunities, even if at reduced valuations. The bottom third will continue to need to sell out or shut down. The middle third is likely where things will change the most. VCs and founders were spoiled in the recent runup with many mediocre performances still earning follow-on rounds. This feels far less likely now, and companies in the middle third should instead seek solid exit opportunities or cash flow breakeven.

Good luck to all and remember that in the asymmetric performance curve of startups, iconic companies can and will be built during downturns.

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