The past few months have hit the startup community where it hurts — the balance sheet. With inflation rates at record highs, a recession on the horizon and threats of a long winter by venture capital giants like SoftBank, VC money is becoming harder to come by. So where does that leave startups relying on that cash to reach their next levels of operations?
TechCrunch sat down with investors who cover a range of growth stages and industry sectors, with a bent toward mobility and climate tech, to hear how they’re looking at the funding environment today and what their red flags — and green flags — are for startups looking to raise another round.
Most of the investors we spoke to said there is definitely a pullback and general conservatism in funding, with many VCs being a lot more deliberate in their due diligence.
“There is no doubt that investors — especially later-stage investors — are largely sitting on their hands, using this new luxury of taking their sweet time and picking carefully,” Nate Jaret, general partner at Maniv Mobility, told TechCrunch. “The fundamentals of venture investing have not changed, only the pace.”
George Kellerman, managing director at Woven Capital, shared similar sentiments, noting the change from last year, when investors would commit funding even before a round had completely come together. Woven Capital is the corporate venture arm of Woven Planet, a Toyota subsidiary that innovates and invests in new technologies that can change the way people move.
“Now what we’re seeing is people are really digging into the company’s pro formas, making sure they’re not underestimating the amount of capital that they’re going to need,” Kellerman told TechCrunch. “Nobody in this current environment wants to say they’re raising money for the next 24 months and then in 12 months come back and say, ‘We ran out of cash.’ And no fund wants to report to their LPs that they made an investment and 12 months later it’s dying or losing money.”
Expect a wave of companies going up for sale
It shouldn’t be surprising to hear that we’re likely to see many companies fold over the next six to 12 months, especially not after warnings from capital firms like Sequoia Capital and Y Combinator telling founders to brace for a market downturn.
A lot of companies are afraid to raise money at the moment due to the conservatism in the market and will therefore try to squeeze through another 12 months with what they’ve got and hope that the market rebounds. Many of those wait-and-see companies might be the first to go, said Kellerman, who noted a decrease in inbound activity. And he doesn’t think the market has hit the bottom yet.
“Those companies that delay, the financial reality is just going to hit them,” said Kellerman. “And if they’ve got 12 months of runway today, in six months when they’re at that point where they’ve got to start fundraising, if they don’t have line of sight to actually be able to raise money, they’re all going to turn to run out of cash and put themselves up for sale. I think we’re gonna see a lot of distressed asset acquisitions.”
Not all industries are affected
On the bright side, Alexandra Harbour, a principal at Prelude Ventures, said that early-stage climate tech is one field that hasn’t experienced a slowdown in terms of dollars deployed, which makes sense. There is currently a huge demand for technology that can make a difference in the climate crisis and that means product-market fit. Several founders, including Don Burnette at Kodiak Robotics and Ritu Narayan at Zūm, previously told TechCrunch that because their services (autonomous trucking and school transportation, respectively) are so vital to the public right now that they haven’t experienced similar difficulties in raising funds.
Red flags for investors
No dedicated CFO
A lot of startups don’t have a dedicated chief financial officer, even into the Series C stage. They might have a head of finance or someone who does their books, but if they don’t have a strategic finance person on board, that might be a red flag because it could indicate that a startup hasn’t modeled out contingency plans and can’t accurately forecast where the business is likely to be.
“A lot of times the fundraising really falls to the CEO or maybe some other executives. I want to make sure that they actually have a solid finance team and really have their hand on the wheel, that knows what the levers are to accelerate them or slow them down and be really, really thoughtful about that,” said Kellerman. “They may have 24 months of runway today, but if something unexpected happens, do they already have those contingency plans in place?”
In other words, it doesn’t matter how good your tech is if you go out of business because your company doesn’t have a strong finance mindset. Kellerman wants to know how the startup will not just get to the next financing round, but how it’s going to generate cash. How will you bring in non-dilutive cash rather than continuing to fund on equity?
One way that Kellerman can tell which startup doesn’t have a dedicated finance executive is by looking at their pro formas.
“I’ve seen some companies create a 24- or 36-month pro forma, and when you start looking at the underlying assumptions, they just took a formula and dragged it across the Excel spreadsheet, and that tells me they don’t really understand their business,” said Kellerman. “The costs, for example, as a percentage of the business should be scaling — they should be getting more efficient the more sales there are. And sometimes startups don’t have that sophistication even in their model. And you can pick it out right away and you’re like, wait a second, if you have this level of revenue and sales, why are you still at this cost structure?”
Similarly, having a team or a CEO that’s successfully navigated economic downturns in the past is incredibly valuable to investors today, according to Cassie Bowe, a partner at Energy Impact Partners.
Spending on the wrong things
“Founders who aren’t controlling marketing budgets and ad spend that are seeing the rising costs of ad units make investors skittish,” Andrea Walne, general partner at Manhattan Venture Partners, told TechCrunch.
Take a look at your balance sheet and decide what is actually needed for operations and growth. It’s really easy to spend too much on business units that don’t necessarily help achieve those aims when you should be focusing on product. For example, Kellerman argued that jumping the gun on hiring salespeople can be a red flag. This nugget of wisdom is probably best showcased in anecdote form:
Kellerman told TechCrunch that a startup was seeking investment solely as a bridge to get them through the next six to nine months before going public via a special purpose acquisition company, or SPAC. This is fairly common, and not usually cause for concern, but Kellerman said the company planned to use that money to hire a bunch of salespeople, so that by the time they went public, they’d be able to claim that they have an established sales channel.
“Well, what happens if the SPAC doesn’t happen? We’ve lost all our money, you don’t have any more sales, and now you don’t have the exit that you thought you did,” said Kellerman.
It’s not necessarily the salespeople that were a red flag to the investor, because a company could just as easily work that into their business plan by showing that every time they add a salesperson, they increase sales by X. In this case, adding a sales team wasn’t part of the startup’s scaling plan — the startup was trying to demonstrate that it was ready to be a public company, but in doing so, Kellerman said, showed a concerning lack of thought.
Too much executive turnover
Oftentimes in startups, the executives are either founders or they’ve been there since the beginning. If they really believe in the business and its viability, Kellerman said he expects them to stick around.
“But if they’re seeing the writing on the wall, and they’re like, ‘This business isn’t gonna make it; I’m going to jump ship early,’ then that’s a red flag,” said Kellerman. “You want to make sure that the leadership is really in place and committed.”
High previous round and high cash burn
Bowe told TechCrunch that an oversized previous round could be a red flag for investors and that it’s a lot easier to have conversations with founders that had a more reasonable last round. To that point, if a high round is coupled with high cash burn, investors might not be too keen to take the risk.
“The businesses that have had more trouble fundraising are those that require raising large amounts of venture debt and equity money without a clear line of sight to achievable proof points that will justify a markup at their next raise (think very capex-intensive hardware plays),” said Harbour. “For these companies, we’d be looking to invest alongside a strong syndicate of investors with deep pockets that can lead an internal round in the case that bridge capital is needed.”
That said, Harbour said Prelude is still interested in hardware/capex-heavy business, but will more closely scrutinize milestones to understand risks to subsequent fundraises.
Green flags for investors
Focus on the fundamentals
“Investors are homing in on their thesis discipline as the biggest driver for diligence in today’s environment,” said Walne.
While investment opportunities are still highly competitive at the early stage, there is a renewed focus on the fundamentals, like revenue. To that end, valuations have come back down to earth versus where they were in late 2021 and early 2022, so investors are keen to work with founders who have realistic valuation expectations based on their fundamentals, said Harbour. This is particularly true given that many late-stage growth investors have paused funding or are unwilling to fund at the types of massive markups seen in 2021.
24 months of runway
In the past, startups might have gotten away with 18 months of runway. Today, investors are asking for around 24 months. Unless, of course, you’re seed stage — then 12 months is OK, Kellerman said.
“The companies we’re looking at may have some revenue — with the exception of Nuro, which was our first investment and they weren’t generating revenue at the time,” said Kellerman. “But we want to make sure they can weather the next couple of years. And to me, that’s not about the market dynamics going on. It’s just kind of fundamentals.”
A lot of this feeds back into Kellerman’s suggestion that startups invest in a good CFO, someone who can lead the finances strategically. Jaret offered similar sentiments, encouraging investors to continue to demonstrate the same grand vision as always, but with a delicate overlay of fiscal responsibility and maturity.
“You are custodians of your investor’s capital, and they are in turn custodians of their LP’s,” said Jaret. “An investor’s biggest fear right now is that in 12 or 18 months, the funding environment will make it yet harder to get that next round done. Now is not the time to try and slip inflated budgets by investors or propose one-year runways.”
Contingency plans
Included in that runway strategy should be contingency plans. There’s no denying we’re dealing with economic uncertainty, so Bowe said it’s important for founders to be forthright about all the ways they plan to navigate the constantly changing world.
“What might your next round of financing look like? And how much capital do you think you need toward profitability?” said Bowe. “It used to not be as much of an issue to raise a lot of future capital and now that’s a question that people are taking seriously.”
Kellerman said this kind of planning will not only help startups secure funding but will also help them avoid desperation funding and fire-sale exits.
Accepting humbler valuations
As Harbour said, valuations are coming back down to earth, in large part due to inflation. For example, in the first quarter of this year, the average valuation of a Series A round declined around 25% and a Series C valuation dropped around 42%.
A suboptimal valuation, while maybe not ideal, is not a hill to die on, said Jaret, who reminds startups that founder dilution can always be corrected if it dips to unpalatable levels and that responsible investors know this and rarely object.
“Suboptimal isn’t the same thing as predatory — VC reputations must be built in years of famine, not years of plenty,” said Jaret. “Founders have a responsibility to keep the gossip wheel quietly turning amongst themselves in order to purge the bad behavior that investors can sometimes get away with in times like these.”
Be a category leader in your space
“I think the green flag right now is finding category leaders to invest in what we think could be platforms for roll-ups, so a company that we think is a leader and could acquire a lot of other companies,” said Bowe. “That has been a difficult strategy when the market was so hot, but with the market where it’s at, I think that there could be some really interesting roll-ups and acquisitions that the leaders could make and something that we’re really looking out for and excited about.”
Don’t be afraid to collab with VCs
It’s the job of VCs to be tapped into the market in which your startup is currently trying to raise. Trust them to work with you to find the right amount that your company might need. Bowe said a green light for Energy Impact Partners is startups that are having more collaborative discussions with investors about their round size and valuation rather than coming out with strict raise amounts.
“Being more collaborative with potential investors is better right now,” she said.
Companies with a clear vision
This one sounds obvious and arguably is essential no matter what market we’re in, but Kellerman said about half of the early-stage executives pitching him couldn’t articulate a clear vision.
“Startup leaders are creating the future. Telling a logical and compelling story is essential to inspire teams to follow you and overcome doubts,” he said.
Comment