When it became clear that the public market had forever descended from the peaks of 2021, venture investors decided to break camp and head downhill as well, advising their portfolio companies to focus on lowering their burn because capital had suddenly become expensive.
Why the focus on cost-cutting? Because conserving cash is an easy way for startups to postpone fundraising, giving them more time to both increase their revenue and potentially wait for tech valuations to recover.
But new data indicates investor preference is moving akin to a pendulum: They wanted startups to scramble and change their focus from a “growth at any cost” mindset to becoming profitable at low cost when things went to hell, and now they’re already looking for growth again.
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For startup founders, the rapid change in investor preferences may feel like a whipsaw. But such an evolution in market preferences is actually rather logical and, frankly, somewhat boring in how it plays out.
To illustrate, let’s first look at the data, and then let’s talk about what startups should take away from the information. After all, it’s the weekend, so we can stretch our legs a little. To work!
What the data says
The cloud team at Bessemer — the venture fund that built the public market cloud index that we often use as an indicator of tech valuations — has put together another yearly report that came out this week. (Website here; Slideshare pullout here.)
One of the most interesting pieces of data in this report compares the relative value of 1% of revenue growth with a 1% improvement in free cash flow.
Free cash flow, in case you are wondering, is one metric many startups use to measure profitability. It’s pretty far from net income, but for a company that has to estimate its life expectancy in terms of months left until cash runs out, it’s useful.
Back in late 2021, Bessemer writes, “a ~1% improvement in revenue growth had the same impact on public cloud valuations as a ~6% improvement in Free-Cash-Flow (FCF) margin.” In other words: Startups could generate six times the value by accelerating growth by 1% than by cutting their burn rate.
At the time, money was cheap, meaning that investors were less interested in low-yielding investments like bonds and more interested in other sources of growth. That, combined with an economy staggering in the wake of COVID-related restrictions, led to tech companies spending like mad to grow.
The erstwhile 6:1 ratio was favorable for startups because venture-backed tech startups are not built for profitability, at least in the near term. They are built because they have an angle, edge or perspective that allows them to scale a technological solution rapidly, creating gobs and gobs of high-margin revenues. Profit comes later, which is why startups raise lots of money and spend it to grow and build a very valuable business.
But even if we expect startups to generally prefer a market bias toward growth over profitability, that 6:1 ratio feels a little extreme. What came afterward, when the tech market fell off a cliff, also feels extreme: Investor preference swapped from being skewed toward growth to an even balance.
Here’s Bessemer:
In late 2022, this ratio moved closer to ~1:1 and even tipped slightly in favor of profitability.
This helped lead to, in part, a lot of belt-tightening at startups. It also helps explains the waves of layoffs at larger tech companies, not to mention the absurd mountains of venture capital tweets and threads.
But then things changed once again. The market is getting warmer for the startup model now:
Today, with more macro stabilization, the ratio stands at 2:1 in favor of growth, where a ~1% improvement in revenue growth has the same valuation impact as ~2% increase in profitability.
Growth is back on top, y’all!
A 2:1 preference for growth over profitability may not sound like a lot when we consider the 6:1 ratio of the recent past, but it’s material all the same. And it engenders an investing climate that lets small companies better defend raising venture capital. After all, if there’s just as much to gain from savings as there is growth, why raise a lot of capital only to spend it and generate greater losses?
Your burn rate shoots up when you raise capital because then you have to spend it (remember this media cycle?) to pursue more and perhaps even faster growth. But the catch is: That model only works so long as that growth is worth pursuing.
Back in 2014, Mark Suster wrote that a startup founder’s “value creation must be at least 3x the amount of cash [they are] burning or you’re wasting investor value.” If the market is rewarding profits, or cost cuts, you can’t generate 3x returns on capital that you raise, because the market isn’t rewarding high-burn growth. In contrast, the greater the market bias toward growth, the more it makes sense to raise a lot of capital and push it through even an inefficient go-to-market motion.
Is a 2:1 bias for growth over profitability enough to let startups breathe easy, raise capital and generate investor surplus through rapid revenue expansion? Probably not. But directionally, the growth:profits pendulum is heading in a direction that will help create an environment in which the startup-venture model can once again create lots of value through expensive growth.
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