What is going to change in Startupland in the aftermath of SVB?
No, it’s not back to business as usual for startups after SVB. Or at least it shouldn’t be.
In the immediate aftermath of Silicon Valley Bank’s demise, our firm spent a tense weekend preparing ourselves and our clients for the worst. Thousands of startups and small businesses faced the very real prospect of missing payrolls and triggering layoffs to survive. The industry was on war footing trying to develop responses should it face a cascade of failures across the tech landscape.
Fortunately, the U.S. Federal Deposit Insurance Corporation (FDIC) averted catastrophe by stepping in to guarantee all deposits. Meanwhile, HSBC rescued the assets of SVB UK to safeguard money. To be sure, the banking crisis of confidence has not been entirely contained, as evidenced by the emergency acquisition of Credit Suisse by UBS. But widespread chaos some of us feared in the tech sector has not come to pass.
But just because tech cheated the apocalypse doesn’t mean it can go back to business as usual. Tech funding and valuations were already facing a reckoning thanks to macroeconomic changes in 2022. SVB’s collapse will add new dimensions to these headwinds that mean startups must further ciment their economic engine.
Let’s look more closely at why that is, and how founders and investors should respond.
The venture debt risk
My goal isn’t to deliver a post-mortem on SVB, but rather to look ahead. Still, it’s important to remember the context of how tech funding was already changing in 2022 because that catalyzed an evolution in SVB’s support for innovative companies that is important to understand.
Following the boomtimes in tech fundraising in 2021, the macroeconomic slowdown coupled with inflation and interest rate hikes by central banks caused a sea change in fundraising last year as stocks of unprofitable companies collapsed.
One of the key reasons was the retreat of alternative investors from tech, particularly in late-stage funding. In recent years, private equity, mutual, and hedge funds had turned to late-stage tech seeking big returns and writing massive checks that massively inflated valuations for companies seeking an alternative to entering the public markets.
As global economies downshifted and public markets sputtered, these alternative investors closed their startup checkbooks. For example, look at Tiger Global, which had become one of the most aggressive PE funds in tech. The Wall Street Journal just reported that Tiger marked down its startup investments by 33% in 2022, erasing $22bn in value.
Ouch. Still, somewhat surprisingly, that flight didn’t immediately tank startup valuations as drastically as one might have predicted. Consider the following:
- Fall of public market valuations — According to CB Insights, the top 50 tech IPOs since 2020 currently have a market cap of about $443.6bn, down from a peak of $1.086 trillion. Let’s take a look at the 20 largest Tech IPOs, 18 of them being way below their IPO valuation. Cf. infra.
- Changes in number of deals, fundraising: CB projects that globally, the startups will raise $56.3bn in 5,792 deals, a dizzying drop from the $151bn raised in 10,922 deals for the same period one year ago. CB Insights predicts that funding and deal count are projected to drop 16% and 26% quarter-over-quarter (respectively) by the end of Q1’23.
- As such, the average time between funding rounds is increasing across all stages, according to CB Insights. The median number of months between rounds rose across all deal stages from Q1’22 to Q4’22.
And yet, private tech valuations have not collapsed to the degree one might have expected: At the end of Q4 2022, almost all valuations across stages were down from their 2021 heights, but still above 2020 levels per Pitchbook data.
So, what happened? With that big-ticket money drying up and VCs becoming more cautious, startups sought financing alternatives. One of the most popular solutions: Venture debt. These are large loans that are attractive to startups because they deliver financing that is far less dilutive than direct equity investments but still manage to prop up valuations until conditions are more favorable for a classic funding round.
The rise of venture debt in 2022 helps us understand why startup valuations have not fallen as sharply as those of public companies. According to the Pitchbook-NVCA Monitor, startups in the U.S. borrowed $32bn in venture debt last year, up from $7.5 billion in 2012. In Europe, the trend was similar though in much lower proportions.
As it turns out, SVB had become a major source of venture debt, accounting for $6.7bn of those loans last year. While the FDIC saved clients’ deposits and accounts, SVB won’t be making any more of those loans. This is another blow to companies either having trouble raising a round, or at least hoping to delay in the hopes of avoiding a haircut on their valuation.
That means that more of these startups will have to fundraise in this tough environment. The drop in valuations is now coming to VC land. Founders and investors, once again, must recalibrate their thinking and strategies.
Founders, make the tough calls
The good news is that there is some good news. Despite the grim picture I’m painting, a lot of funding is still getting done, and sometimes at great valuations.
Companies attracting investors and strong valuations despite these macro conditions are market leaders in new categories that have reached the scale where they have right unit economics. During their scale-up phase, these companies have been relentlessly focused on their metrics. At the time they go on for fundraising, they can show customer efficiency at client and product level (i.e. at the right granular level) and prove that.
Of course, this attention to metrics is something that founders should have been doing from the start. But even though it has taken on new urgency as investors emphasize profitability, we still find that far too few founders are focused enough on the right types of metrics. Not only will this make fundraising more daunting, but it could also put the very survival of the business at risk.
The time for passively sitting back and hoping the funding tides will turn is long over, especially if the crutch of venture debt has been yanked away. Founders must urgently assess their cost structure from top to bottom. Every dollar spent should have the right ROI now.
In response to this fast-moving situation, we are developing a tool that provides a rapid analysis of the key elements of cost structure so founders can better assess their situation by dissecting the elements of their business that drive cash burn. Part of the goal is to ensure you have insight into that cash burn to be clear about what spending is driving revenue and which expenses are a drag on profitability. Even if no immediate change is needed, having a set of scenarios for the coming months could help you reduce your burn at a moment’s notice if conditions change or the funding window remains shut for an extended period.
As we put together this tool, one of the key metrics our firm has found that leads to problematic rates of cash burn is ARR per FTE. To put it more directly: Too many companies are still overstaffed relative to their fundamental unit economics.
We’ve seen Big Tech companies in the U.S. take aggressive action to bring those ratios back in line by announcing an astonishing number of layoffs. Whether these cuts are too aggressive remains to be seen. But it’s clear that many founders — especially in Europe — are not being proactive enough when to comes to making tough decisions about their cost structures due in large part to a mix of cultural differences.
Now is the time to find the courage to make those difficult decisions, especially when it comes to headcount. You might have enough cash in the bank, but if the cash burn is not sustainable, you may not be able to access the next round of funding in time to keep the company afloat (and to preserve your valuation, at least in part). You are putting your company at great risk if you don’t deal with your cost structure before your money is running out.
This latest crisis has not diminished our overall optimism about tech in the coming years. The major macro trends driving digital transformation still represent massive opportunity for investors and founders. But leveraging their potential will require greater vigilance and discipline. That starts with facing reality and making hard decisions now. This will lead to better survival rates amongst startups and to many opportunities for Private Equity as some of these companies become “fixable” and embrace a different track than the one that might have been the first choice.