Why I’m Not Telling Every Startup To ‘Pull The Brakes’ Just Yet
Here’s how I’ve generally described what’s occurring in tech land over the last few months:
- For a variety of reasons, technology companies were being rewarded with valuation multiples which far exceeded historical norms and the view on their growth rates, amount of capital they could/should spend to capture revenue/market share, etc were incredibly rosy.
- Similarly, for a variety of reasons, the music stopped. Multiples dropped in public and private markets, growth expectations were cut, and business models with high spend for promise of future ROI became quite unfavorable.
- The ‘valuation multiples’ reset also came with an increase in slope of the curve. ‘Great’ companies took 1–2 steps backward, ‘good’ companies 3–4 and ‘average’ companies 5–7 (symbolically). As a result, there’s a lot of incentive to remain a ‘great’ company, which is still venture investable, versus falling into a trough of uncertainty.
- But you need to remain great and investable while also managing your costs, extending your runway, tightening your operating plan, and so on. Not buying low quality growth. This is challenging but definitely not impossible.
- What’s the biggest open question for most companies in remaining ‘great?’ Top line growth and margin. Are you indispensable for customers? Do you understand your cost structure and can you manage to a forecastable growth rate. And so on.
- Continually missing top line projections in this environment is DEATH. Your runway is impacted by the absence of projected revenue. A drop in growth rate turns into a drop in valuation multiple. And your investors start to worry that you don’t have a great handle on your business, which means any new capital infusion could be eaten up without getting to the next milestone successfully.
Let’s avoid giving overgeneralized advice such as “every company should have 36 months of runway” because it’s just not true (and sometimes destructive, per Sam Lessin’s tweet and David Sacks ‘default investable’ framing).
Instead I’ll suggest there are two specific questions that really matter, the answers to which will have the biggest impact on the next 1–5 years of startups and venture capital.
A. Is This a Tech Recession or a General Recession?
The former largely means the folks with operating risk are Series A and beyond tech startups selling to other tech companies. The latter means that every Series A+ startup has to reforecast. In either case, you gotta assume that the goalposts have moved a bit forward for the next round, especially if you’re trying to grow into and surpass your last valuation.
But one of the benefits of ‘software eating the world’ is that there are a ton of amazing companies selling into huge traditional industries: agriculture, health care, government services, hospitality, and so on. I’d argue that these are generally less exposed to a tech chill and more exposed to a general economic slowdown. While the ‘red hot economy’ days seem to be over, a soft bounce or mild growth US market won’t necessarily impact all startups the same. Unfortunately the risk of a 2023 recession seem to be increasing, although economic pundits are largely still in the 25–50% probability bucket.
Note: I don’t want to hear seed companies complain about “the market.” You literally just showed me a deck that said your TAM was 10,000 customers. If you can’t find 10, 20, 30 in 12–24 months it’s not the market, it’s you.
B. Will Categories Create Multiple $5b+ Startup Outcomes, or Back to Majority $1–5b Single Winners?
A few quarters back the CEO of a buzzy startup and I were DM’ing about the state of the market. He and I had grown up in a world where $1b valuation was rarified air and you assumed that most markets were winner take most. Instead we were seeing private investors accelerate companies to — and well past — the $1b threshold, and many of these valuations growing even further in the public markets. It seemed that the outcomes were bigger than we ever anticipated and each vertical could create multiple huge winners because of market size, massive global reach, and so on. Paraphrasing, he basically said this was “either what it looks like when ‘software eats the world’ or things had gotten overheated.”
Looking back now it’s easy to insist it’s just the latter, but I’m inclined to believe that both are true. There’s been a lot of chatter about how consumer habits were supercharged during peak pandemic and have now snapped back to normal. We forget that ‘normal’ was still pretty rapid movement to online connectivity, services and shopping. That’s not changing. At the same time, the back offices of SMBs/SMEs have started to SaaS’ify at an increasing rate. And they’re not going back either.
If I’m wrong and the markets are smaller than I think, and the multiples on these companies remain compressed, we’ll see fewer $5b+ exits. This will return us to a more linear capital model, where ownership percentages for investors matter and there’s fewer private growth rounds at escalating $1b -> $5b -> $10b+ valuations. A $1b outcome feeds some funds who are either smaller and early, midstage and ownership heavy, or later stage and underwriting to a 2.5x. A $10b+ outcome feeds *everyone* on the cap table and the collective belief that an extraordinary number of startups could reach and eclipse this milestone drove a lot of the momentum investing of 2019–2021. Fewer huge outcomes means less late stage private capital and continued power law returns among the best venture funds.
Note: Calling the hedge/crossover funds “tourists” is a misunderstanding of their model. They’re not tourists, they’re owners of multiple residences: a city home, a mountain home and a beach house. They reside in each house based on the season and vibes. That is, they invest in high growth private (venture), profitable growth private (more traditional PE) and public markets. And they bring capital to each of these markets (and take from the others) based upon the risk/reward. Right now there are a lot of public market stocks which look attractive compared to private startups. They’re not tourists, they’re optimizers.
Ok, so that’s what I believe at a macro level. The two questions that will have the greatest impact on startups and venture over the next few years, and potentially the rest of this decade.