Startups need to evolve from a unicorn to a cockroach
Startups need to evolve from a unicorn to a cockroach
Generate free cash flow, drastically reduce burn or die
This will be a two-part post covering the ongoing public and private market reset, especially within the tech sector. The first post will offer my own perspective on what recent events imply for startups. The second one will take these implications and extend them to engineering organizations.
Caveat emptor.
I should emphasize that what I share is entirely my perspective. I am not a VC or a CFO. Additionally, whatever I share here is not reflective of my professional experience or companies I work at now or in the past.
The public market perspective
2022 saw a huge reset in the stocks of once flying tech companies. Many of the high flying names came crashing down. But just how far has this reset been? The chart below, courtesy of Meritech, shows the magnitude of the valuation drop on some of the more notable public tech companies. Companies that were once commanded a median valuation of ~40x ARR are now valued at about 12x. That represents a 70% discount.
While we do not have similar data for private companies, it should be obvious that a similar reset is bound to happen in the private tech company sector. The immediate impact of this reset is diminished valuations and in some cases this valuation compression might be perpetual. Startups that raised at 100x ARR might never be able to grow into this frothy valuation.
Valuations aside, the public market reset also poses ongoing concerns for private companies, namely their ability to raise more capital. The assumption that money is freely available is no longer true. Startups that assumed that the capital markets were always there to fund them for the next stage of growth now have to deal with a different reality: capital isn’t there. The implications of this new regime, one in which capital is expensive and scarce, will have significant implications on startups.
The views I will offer will differentiate between late stage startups (series-D and beyond) and those at earlier stages. The earlier you, the more degrees of freedom, to a certain extent, you have.
Late stage startups
My definition of late stage startups are those that have raised a series-D or beyond. The implications to this segment of startups will be most profound, because their options are very limited. I will explore some of these options - my analysis might not be exhaustive - and my opinion on the plausibility of each.
Option 1: IPO
I am putting this option on the table for the sake of completeness. Realistically speaking this isn’t an option for the vast majority of startups at this stage. An IPO is an exceedingly difficult and rare event in the best of times. The IPO window is slammed shut, and will continue for the foreseeable future.
Option 2: Raise more capital
Last time I checked there were about 1200 companies with valuations greater than $1B. The coveted unicorn club. That was in the good times of free and abundant money. The best case scenario for some of these companies would see them with a valuation reset similar to the one observed in the public markets. Maybe then they might be able to raise additional capital?
The reality is the majority, if not all, of these companies cannot raise more capital at the lofty valuations they commanded a year or two ago. Additionally, they all face a risk of not finding any sources of capital. Why would VCs pour more money in a startup that has raised hundreds of millions of dollars with no means of attaining profitability and financial independence?
The best outcome for some of these companies would be to raise additional capital under terrible terms. The more plausible one is to simply assume that there is no more capital to be raised. Survive or die. Many will die, even ones that were inches away from IPO-dreams.
Option 3: M&A
The M&A option is really an option too. First, I don’t believe that a company’s strategy is to be acquired. A company should strive to build a long lasting and profitable business. For those that might be holding on for an acquisition, the chart below offers a bleak view of the M&A market. It has plummeted.
Not only has activity plateaued, but transactions >$1B (remember this is the unicorn club) are exceedingly rate even in the good times. A unicorn hoping for an M&A transaction in accordance with its last valuation has better odds finding a real unicorn.
Option 4: Financial independence
I argue that there is one and only one choice for companies in that stage: financial independence. These companies have to dramatically adjust their cost structure, and growth aspirations, to attain positive cash flows (and FCF). This financial independence will come at the expense of tapering growth, which was historically inflated by free and abundant cash. The future growth has to be self-generated, even if the rate of growth is significantly lower.
Financial independence also offers the most optionality. By attaining this independence, the startup can wait (hope) for the return of a more favorable funding environment. But the first and most pressing order of business is to adhere to an operating plan that allows the company to grow whilst generating sufficient cash to run the business
Early stage startups
My definition of these startups are ones post-seed up to the B or C stage. Similar to the earlier section on late stage startups, I will explore the options these startups have and my opinion on the plausibility of each.
Option 1: IPO
Sorry, this isn’t really an option here. Moving on.
Option 2: M&A
Similar to the late stage startups, the same constraints apply here. However, because some of these companies might have valuations < $1B they might be able to find a suitor. Regardless, my opinion is unchanged: the goal is to build a long lasting and successful business.
Option 3: Raise more capital
This might be easier for these earlier stage companies, but the terms will be dire. Dirty terms with liquidation preferences that will wipe out all current preferred and common shareholders will be the norm. Maybe you have good growth, good unit economics and can command clean terms at a steep discount, but don’t count on that.
Option 4: Plan for 2+ years of no capital
This is a derivative of the cash flow positive option for late stage companies. I relaxed the requirement from generating positive cash flows to running the business for 24+ months with no outside capital. I did that, because the capital required to fuel the (accretive) growth of these companies cannot be funded alone by the cash the startup generates. Many startups at this stage will almost certainly need additional capital. The most desired position to be in is to fuel your growth organically with no additional capital, but that is hard and rare at this stage.
I pick two years because I suspect that this will be the earliest the capital markets start to thaw. If you can extend the timeline beyond 2 yrs, you should.
In my opinion the choice that any startup has is to generate positive cash flows to survive indefinitely, or for as long as this down cycle lasts, which might be 2+ years. I’d argue that any startup must do that regardless of stage or its run-rate from available capital.
The implications are obvious and hard. Most startups have cost structures that are still premised on being able to raise cheap capital every 18-24 months. Hence, their ongoing cost structures are not sustainable. They will have to retool the company - every part of it - to fit into a more sustainable cost structure. This in turn will have implications on growth.
If there’s a blessing in disguise, it is the following: many startups will not survive the next 12-24 months. The ones who do, will benefit from a landscape with fewer companies that compete with them for customers and capital. Survive to have a chance to thrive.
In my next post, I will address what that means for engineering organizations in this new parsimonious world.