The Macro Landscape in Tech and Venture - Oct 2022
The US, Canada, Europe and the UK are all either already in a recession, or have a high probability of entering a recession soon.
This is negative for customers, investors, lenders and acquirers – i.e. all the main sources of cashflow for your business. You should plan your strategy accordingly:
Sales: be prepared for longer sales cycles, lower conversion rates, higher churn, and in general a harder market to sell into.
Financing: if you have lots of runway and you are confident of PMF, you can consider ‘playing offense’ to grab market share and talent – but be aware it’s a high-risk, high-reward move. If your runway is short or your PMF is uncertain, you should move decisively and early to change those.
Company-building: now is the time for discipline, frugality and focus. Know your numbers, know your options, and be prepared.
How We Got Here: Macro
For the last few years, western central banks have followed a policy of ‘easy money’ – low interest rates and easy access to capital. This led to economic growth via increased spending by both consumers and businesses.
However, too much easy money often results in inflation. This came true with a vengeance in 2022. It was exacerbated by an energy shock (Russia invading Ukraine), supply chain issues, and worsening global trade relations (esp. between the US and China) – all of which caused prices to rise.
To curb this rise in prices, and especially to prevent inflation from becoming a self-fulfilling prophecy, central banks around the world have been ‘tightening’ their monetary policy. Their explicit stated goal is to stop inflation by reducing consumer and business demand for goods and services – which almost always results in a recession.
How We Got Here: Tech
Most parts of the US economy – manufacturing, agriculture, hospitality, media, energy – grew slowly or not at all in the 2010s. The big exception was tech.
This prompted a lot of people to invest in tech, and that’s where a lot of the ‘easy money’ ultimately ended up: in tech firms directly (via VCs and PEs and HFs), in tech worker salaries (via FAMAG salaries trickling down), in real estate catering to tech workers (SF, NY, Toronto), in services selling to tech workers as their core audience (Airbnb, Wealthsimple, Stripe et al), in consultants and lawyers and investment banks serving tech clients, in tech firms selling to each other and so on.
Now that the easy money is being withdrawn, all those sectors are likely to be hurt.
Layoffs and Retrenching
We’re seeing this play out. It started with the ‘lower quality’ tech companies getting hammered in the stock market or in late-stage valuations. But now even the ‘blue chip’ names like Google and Apple are down by 20-40% or more.
Every single major tech firm has announced hiring freezes, and most have also announced layoffs. Behind the scenes, they are also cutting costs where they can – everything from office perks to AWS bills to SaaS spend.
Chances are, your customers will (directly or indirectly) be affected by the looming recession, and this in turn will affect you. At the very least, you should:
Expect that sales will be an uphill battle unless you offer clear and compelling value to your customers. You can’t fake or postpone PMF.
Expect tighter buyer budgets, longer sales cycles and lower win rates. Have a plan to navigate this and incorporate it into your financial models.
Watch out for churn driven by top-down cost-cutting directives. Ideally you want to be ‘the last thing’ that people cut. If you’re not, find out what you can do to become that ‘last thing’.
Watch for leading indicators of trouble. Forward-looking intel from the sales frontlines (both tangibles like length of sales cycle, and intangible “vibes”) is especially valuable right now.
Tilt upmarket. A lot of SMEs and start-ups are going to fail in the next 2 years.
Tilt your messaging towards savings and efficiency for your clients, instead of growth and new opportunities. Faster-better-cheaper instead of brave-new-world.
Try to get paid upfront, and close long-term deals. Now more than ever, cash is king.
And play that game in reverse: ask vendors for deals and credits, threaten to churn, negotiate delayed payments or big discounts for cash on time etc.
A few tactical principles are more important than ever in this environment:
Do less. Focus on what’s important. Ruthlessly eliminate tasks that are not priority. If it’s not existential, ask if you can do without. Understand the company-killing risks, and fix those first. Ignore everything else.
Execute fast. Speed multiplies your runway.
Hustle. Be creative. Get shit done.
Be frugal. Spend as little as possible. (But not less than that!)
Make sure your team is on the same page on all of the above. When hiring, select for people who can work this way. You need guerillas, not generals.
Celebrate your wins – and in this market, everything is a win.
The Venture Slowdown and (?) Reopening
Every stage of the venture funding ecosystem relies on demand from the stage after it. When that downstream demand dries up, upstream funding also stops:
- The Nasdaq peaked in Nov 2021.
- IPOs stopped coming to market shortly afterward.
- Late-stage tech fund-raising (Series C, D, E: aka the pre-IPO rounds) stopped in Q1 of 2022.
- Series A and B deals stopped in Q2.
- Seed deals largely came to a halt in Q3.
The big question this summer was whether 2022 was going to be more like 2009-10, when there was a slowdown for 12 months, but funding reopened reasonably strongly after that, or more like 2001-03, when funding markets shut down for 3 years and start-ups either had to be profitable or they died.
So far, it seems like we are in a 2009-10 scenario: institutional seed funding has indeed reopened in Sep and Oct of 2022 after being moribund from Mar through Aug. But valuations have corrected dramatically. Here’s my estimate of the market (all figs USD):
|1-2 on 3-5 pre
|3-4 on 10-15 pre
|1-2 on 4-6 pre
|2-3 on 10-12 pre
|5-8 on 25-40 pre
|3-4 on 12-18 pre
|10-15 on 25-40 pre
|20-30 on 75-120 pre
|12-15 on 40-50 pre
Pre-seed = product under development, hints of traction, <100k ARR.
Seed = product in market, maybe some early traction, 100-500k ARR.
Series A = product ready to scale, concrete traction, ~1M ARR.
As you can see, valuations have corrected by about 50%, but they still haven’t quite come down to pre-2020 levels. The folks most hurt by this reset are those who raised at high valuations in 2021. They must now ‘grow into’ those valuations or face a down round, and their hurdles are much higher.
Round Dynamics Today
I’ve talked to a number of Series A investors at top firms, and they all say they are ‘open for business’. But a few things have changed:
Valuations are lower. No more 100x ARR at Series A; the market is closer to 40x right now.
Less emphasis on ‘growth at all costs’, more emphasis on capital-efficient growth.
More love for companies that are profitable or close to profitable, and business models that don’t rely on unlimited funding – either for GTM, or for balance sheet eg if you’re a fintech.
More detailed diligence: you need data now, not just narratives.
Less FOMO: no rounds closing in 24 hours, most take 1-2 months.
More ‘structure’ in the terms – liquidation preferences, extra rights etc.
More ‘funky’ rounds – tranches, tweener rounds etc.
If you’re a forced seller, expect games and aggressive behaviour from funders.
Also note that the same VCs who say they are open for business are also advising their own portfolio companies to budget for at least 24 months of runway before they raise their next round. So they’re not being entirely consistent.
Another dynamic at play is adverse selection. If a founder has a choice – i.e., if they have runway – they’re not raising in today’s market. As for the founders who don’t have runway, if the metrics are strong, they’ll raise from insiders (previous round VCs) who know and trust and believe in the business. So that leaves only the founders who don’t have much runway and whose insiders won’t support them. Naturally VCs are cautious about investing in such founders
Given all the above, my first piece of advice is: don’t expect a super strong round in the next 6-12 months unless your traction is excellent.
My second piece of advice here is: the best financing strategy is always to build a good business. In the current macro environment, this means a business that is growing at a reasonably strong pace and in a capital-efficient manner. If on top of that you are at or close to breakeven profitability with plenty of cash in the bank, you control your own destiny.
(Warning: this paragraph is a bit speculative; the landscape keeps changing). My sense is that the benchmark for a good Series A today is probably still around 1M ARR, growing at 3-4x a year. You need to show that your growth is not decelerating despite the broader economic downturn. (Plus, all the points above about capital efficiency, business model etc.) You can probably get a deal done if your growth rate is 2-3x y/y, but it’s likely be a grind, with a mediocre valuation and possibly lots of structure. Below 2x y/y it’s going to be hard to raise in the current environment.
A few general principles make sense no matter what your situation:
- Know your numbers.
- Be prepared for different scenarios in advance; don’t just react to events.
- Be decisive and act fast. Piecemeal actions are the worst of all worlds.
- Be honest with yourself.
- Try to control your own destiny via discipline around spend and growth.
- Above all, do what it takes to survive. Everything else is secondary.
Beyond that, I’m very hesitant to offer blanket recommendations on business strategy. It all depends on your individual position. But here’s the framework I would use.
Strategic Planning Framework
Start by calibrating your business. There are three key factors:
Are you profitable or do you have a clear path to profitability?
Do you have cash in the bank – at least 18 and preferably 24 months of runway?
Are you growing well – at least 10% month over month?
Note that these are all dynamic and feed into each other – runway is a function of cash and profitability, profitability is a function of revenue growth, revenue growth is a function of burn, acceptable burn is a function of runway and so on.
Best practice is to create a high, mid and low estimate for the trajectory of the business. Mid is your best estimate of what will happen; high is what will happen if the recession is short lived (or non-existent) and the economy booms again; and low is what happens if the recession is longer or deeper than expected, with consequences for growth, churn, sales efficiency etc.
Based on that, you will probably occupy one or more lines in this table:
1. Profitable, plenty of cash in bank, growing well:
Do nothing: you’re sitting pretty. Let growth compound. Reinvest profits, don’t rely on external funding, control your own destiny. Maybe consider playing offense: raise a round from a position of strength. Spend a bit more to grow faster. (But I would advise against becoming too unprofitable in this environment; also, any round now is not going to be great).
2. Profitable, limited cash, growing well:
Raise a modest round from insiders if available. Focus on capital-efficient growth: stay profitable and control your own destiny.
3. Profitable, plenty of cash, growting slowly:
Run experiments to rekindle growth. But keep a tight rein on these experiments – don’t jeopardize your runway. It’s okay to burn a little, but be prepared to cut burn rapidly.
4. Profitable, limited cash, growing slowly:
Cut non-essential costs – keep lights on in core business and build up a war chest. Stay profitable, hibernate until the market unfreezes, keep iterating the product.
5. Not profitable, plenty of cash in the bank, growting well:
Can you cut costs without compromising growth? If so, try to build a line of sight to profitability or to the next funding. Build relationships with insiders and new funders. And be ready with a plan B if markets freeze or growth slows.
6. Not profitable, plenty of cash, growing slowly:
Back to the drawing board. Focus all your efforts on finding PMF. Try to extend your runway to 30 months – cut costs if required to do that. You don’t have a fundable business so you need to build one.
7. Not profitable, limited cash, growing well:
Cut costs wherever you can. Priority is to either get to profitability, or extend your runway – otherwise you will have to raise from a position of relative weakness. If possible, raise a round from insiders to buy some time. Otherwise, bite the bullet and raise from new investors – terms will be poor but you’ll live to fight another day.
8. Not profitable, limited cash, growting slowly:
Start-ups fail when founders bail. If you still believe in the mission, stay the course. Pay the bills via consulting, or services. Cut team to founders. Start from scratch again. Remember, there’s always a card you can play.
To be clear, none of this is meant to be prescriptive; rather, it’s an exercise to understand where you are, and what options you have; also where you can go with various actions. Also note that many of you will fit more than one scenario because often the answers are not ‘yes’ or ‘no’, they are ‘somewhat’ and ‘maybe’ and ‘conditionally’.
A Healthier Market
This all sounds like doom and gloom. It’s not. In many ways, it’s good for your business, though it may not feel like it right now!
In the last few years, the venture market has rewarded founders who are good at fund-raising: narratives, hype, self-promotion and fostering FOMO. The winning strategy for founders in such an environment was to paint a big picture with a convincing brush and line up the term sheets – not necessarily to build a viable business.
Similarly, the winning strategy for VCs was to back such founders, in the expectation that other (downstream) VCs would follow on, leading to markups and strong (on-paper) fund performance.
The problem is, this equilibrium sucks the oxygen out of the room for founders who don’t want to play the hype game . It’s harder for them to fund-raise, to hire, to get press, to close customers, everything.
Things have changed. Now a lot of those hype-driven start-ups (who raised huge rounds at high valuations) are struggling, and the market pendulum has swung back to people building real, tangible value for the world.
This means you! My portfolio (hi there!) is almost exclusively this kind of sober, disciplined, “real” business. And the next few years will be a great time to build that kind of business:
- It will be easier and cheaper to hire and retain high-quality talent.
- CAC will be lower – less competition for ad spend and buyer attention.
- Costs in general will be lower – office space, conference venues, software, you name it.
- Fund-raising will eventually become easier, especially if you have a ‘real’ business.
- The customers who stick through this period will be yours for life – a great foundation.
- Your team will be ‘forged in fire’ – strong, committed, capable and loyal. You too.
- You will build a more enduring company – more resilient, lean, hungry, performant.
The key is simple: survive. The next couple of years may be tough, but if you survive them, you will be in a fantastic position. Good luck!