The resetting of the startup industry

Steve Snodgrass / Flickr

Much has changed in the past four months of the technology startup world and how outsiders value the business. Of course it’s too early to predict whether this is a trend or an aberration but the smartest people I know in the industry are predicting the former.

The startup industry may be “resetting,” which doesn’t mean a “crash” but rather just a resetting of valuations, timescales, winners/losers, capital sources and the relative emphasis of growth rates vs. burn rates.

As we noted in our  survey of more than 150 VCs we know in the industry, many saw drops in Q4 valuations last year with nearly all of them projecting decreases in 2016.

Steve Snodgrass / FlickrAnd when prices are dropping on a VCs existing companies in market, there is a substantial reduction in FOMO (fear of missing out) for new deals, which means that investors take their time in making investment decisions. Deflationary economics are well understood – in a market when prices are dropping one prefers to wait a few months to see if prices stabilizes before committing. We do this in our consumer lives with everything ranging from housing purchases to public stocks.

Steve Snodgrass / FlickrWhy does this matter?

The single best (and most important) article I’ve read on the topic was published today by Joseph Floyd asking whether Black Friday was a DiSaaSter or a Reversion to the Mean. That’s economics (or statistics) for asking whether price ratios of how investors value companies was simply coming back to historical norms. You should read the article but I’ll provide the money shot.

Steve Snodgrass / FlickrSo here’s my take away:

• If you raised money in the past 2 years and have grown it is possible that your next round valuation might be flat (or lower) even though you have a higher revenue because investors may value your multiple differently
• Investors are rewarding cautious growth more than high-burn-rate growth at all except the most successful of companies (and even there it may eventually change)
• The smartest companies in the market that I know are working aggressively to lower burn rates through pragmatic cost cutting knowing that the next fund-raising cycle may be unpleasant. This prudence is smart and welcomed
• I’ve heard enough companies say “we simply can’t cut costs or it will hurt the long-term potential of the business” to get a wry smile. We entrepreneurs have been spinning that line for decades in every boom cycle. It’s simply not true. Pragmatic cost cuts are always possible and often productive.
• If you can get a round done at the price you expect – well done. I’m not rooting against anybody. But I would point out that raising money is an existential event and I think in the coming 12-18 months you may see loss ratios (companies going out of business or selling in fire sales) go up. So if your fund raising isn’t moving consider lowering price to shore up your balance sheet and reduce risk. Optimize for a W more than % dilution in these circumstances
• Don’t assume that you can “just do a down round” if necessary. Down rounds are corrosive. Insiders hate them and fight them. Outsiders hate them because they are worried about pissing off your existing investors. Employees hate them because it’s hard to reset expectations that their stock is worth less. Founders hate them because they’re dilutive. The terrible consequence is that some great companies struggle to get financed. New investors often prefer to back newer companies that have never been through this drama.

In my mind this simply means:

• Start early
• Give yourself enough runway but controlling costs
• Be realistic on valuation
• If you need to clean up your own cap table first – while very hard to do – it will make outside funding easier
• If you haven’t raised lots of money in the past be very thoughtful of the trade-offs between easy money (party rounds, crowd funding, leaderless deals) at higher prices vs. more committed capital that can be lower price and harder to raise but more committed in tough times. I am a VC so this will be seen as self serving. But given that I’m not likely to back 99.999% of the people reading this (I do 2-3 deals maximum per year as a VC) I’m really just trying to offer honest advice.

The days of easy money may be slowing down. And please consider readingJoseph’s article on TechCrunch. It applies to all startups – not just SaaS.

Great companies will continue to be built and many will tell you that building a great company in capital constrained markets in some senses builds a more sustainable company. The best deals will continue to get financed. This isn’t a fire alarm. Just a message to less experienced entrepreneurs that the capital markets may have begun to change and if you’re not aware of how this could affect you then you could be a casualty. The last few funding corrections saw many great companies disappear due to bad capital planning / high burn rates.

NOW WATCH: Having blown it on Uber, investor Gary Vaynerchuk shares his lessons on how to spot the next "unicorn"