Turbulence Ahead
Adjust fuel, speed, and destination
Very appropriately, I’m writing this from an airplane on the way to Austin Texas, and we are bumping around like crazy.
I’m going to publish this in far less polished form than I normally would for the sake of being timely.
The point of this piece is to discuss how your startup should approach and deal with bumpy times ahead.
I won’t bury the lede: Startups are encountering headwinds in all aspects of their operations, funding, market acceptance and revenue generation, sales cycles, and hiring.
For those with a long memory, there are echoes of the Sequioa’s RIP: Good Times presentation which first warned of a coming downturn in tech in October 2008.
No one knows how this plays out, of course, and there are some signs of good news, but I’m recommending that management teams prepare—not for a worst-case scenario—but for turbulence.
All your default rules of thumb should be revisited.
I always emphasize the importance in a startup of a big vision that aims over the horizon, but of implementing intermediate-term actions based on achieving a “beachhead” where the startup can establish “revenue, reputation, repeatability, and refuel” and create a launching off point for the next stop on the way over the horizon.
Keeping with the nautical metaphor, current turbulence means that a startup will struggle harder to get to this beachhead, so it needs to load up on more fuel initially, be prepared to pay more for fuel, go slower and slimmer to conserve fuel and choose a beachhead that is closer and safer.
The standard advice in fundraising has been to raise about 18 months of runway, work hard for good terms, and strive for momentum and market share at the expense of burn. The mantra since the 2010s has been “Go big or go home.”
But VC and angel funding is getting harder than it was, and the signals are delayed so we are not even aware yet of how much harder it will be. There’s also a lag at the early, particularly seed (up to 30m) stage, where we may not be feeling this too keenly. Yet.
I am recommending that startups raise more money early on, 24 months of run or more, trim spending to last longer, and hasten to achieve milestones of traction, customers, and revenue.
The goal is to survive winter, in order to recover once conditions improve. Not making massive headway can be survived. Running out of resources during winter is unrecoverable. The survivors will be well placed to take advantage of better conditions when they appear.
Tomasz Tunguz of Redpoint provides a nice visualization:
What’s Changed?
I’ll give a simple description of the various macroeconomic reasons we find ourselves in this situation. The best in-depth description of this I think comes from Aswath Damodaran.
We all know that the trifecta of effectively zero cost of money for a long period, Covid-related measures to bolster consumption, and Covid-related supply chain slowdowns, on top of geopolitical issues such as the uncertainties introduced by war in Europe, have led to rapidly spiking inflation.
How does this affect the investing environment? In the low-interest rate world of a few months ago, the amount of money an investor was willing to pay for a share in a company that generated 4% cash flow, might be $100. What happens when treasuries and inflation start to approach 8%? It then takes only $50 to generate the 4$, so the price of shares will drop to $50. This marketwide multiple compression explains why we are quickly backing off the recent historic highs in the average P/E multiples of publicly traded stocks.
Now, this effect is probably already being priced into the stock market. But this assumes that the company which was generating $4 per share will continue to do so! What if the profits drop to $2? Again, the stock price will be halved, to $25. How far can we drop and what sectors are most affected? Tomasz Tunguz has an opinion.
In reality, this is further complicated because of risk premiums and other factors, but the dynamic described is the essence of the trouble in the markets.
On top of this, there are other issues. Frothy times and money chasing opportunities have been as always been the birthplace of unsound, speculative, and often actually scammy new instruments such as SPACs, and, arguably, some of the cryptocurrency movement. Without throwing the baby out with the bathwater, crypto has enabled the circumvention of safeguards in traditional markets. These have been leveraged to create massive amounts of paper wealth very quickly. Much of that is unwinding at the moment.
A knock-on effect of that is that bad assets are plummeting and dragging even the best of assets down with them. As Scott Galloway puts it, “Nothing will be spared being taken out to the woodshed.” In fact, he should know because his startup Section 4 just laid off 25% of its staff.
OK. How does that affect startups?
The answer depends on the stage. Late-stage companies are seeing their valuations plummet fastest as the expectation of their worth is eroded by multiple compression and reduced earnings expectations.
Earlier stage companies are a bit more immune, as the time horizon for their hitting their stride is more than 5 years, and it could well be that the economy has recovered by then. Matt Turk of FirstMark writes:
seed: plenty of financings still happening at the seed level. No real compression on valuations yet. YC is as frothy as ever. Arguably, the seed stage should be the most recession-proof area of venture, because seed companies are 6–10 years away from a meaningful exit, and no one can predict where the market will be then. Also, checks are smaller, especially seen from the perspective of the very large multi-stage firms that have earmarked hundreds of millions of dollars to seed the seed stage.
and Keith Teare also writes about this compelling, though every day changes things pretty dramatically.
However, even for the early-stage companies, investors are skittish, and poorer on paper than they were last month, last week, and yesterday, so more risk-averse. The best companies may still get funded, but they will not command the kinds of valuations they would have even some weeks ago.
One might think, that VCs have raised and are sitting on massive amounts of cash, and need to invest, so how does that affect me? But this ignores a little-discussed reality: VCs have raised funds, but that doesn’t mean they are sitting on the funds. Their LPs have commitments, but only need to actually provide them when they get capital calls from the VCs. In down and uncertain markets, VCs are reluctant to make capital calls for fear that their LPs will renegué and blow up the fund. They’d rather pretend they’re doing business as usual, have you come in and pitch and keep you in a holding pattern, but press for deals that are more certain and less speculative, as well as being much harsher with their economic terms. Which translates to more traction and lower valuations.
All of which leads me to the recommendations above. Raise more, expect lower valuations, conserve money, and do everything you can to get traction early.
It really bears emphasizing that I’m not predicting the end of the world. I think there are many reasons to be optimistic about the economy and geopolitics, as articulated well by Noah Smith here:
And for startups, as Paul Graham wrote way back in 2008, a downturn may well be a great time to found a startup (though I think he is being a bit Panglossian in that post).
Still, as founders, we are executing at breakneck speed to our plan and can easily get blindsided by changes in fundamental conditions, so I want to encourage you to rethink some of your immediate plans and tactics.
Marc Meyer is a Silicon Valley technologist, founder (6 startups, 4 exits, 1 IPO), engineer, executive, investor, advisor, teacher, and coach. He has invested in and advised over 150 companies. He advises and works with accelerators and funds including Alchemist, 500 Startups, HBS Alumni Angels, and Berkeley SkyDeck, where he chairs the Advisor Council. He has an Executive Coaching and Advising practice helping leaders achieve their greatest potential.