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Friends! Welcome to the weekend. I hope you are resting and recharging. Our work today is pretty relaxed, so pour another coffee and let’s get into it.
The startup growth paradox
This week, The Exchange spent a good amount of time highlighting changes in the startup market. To summarize, the value of tech companies is being re-drafted by investors, and it appears that some of the speculative enthusiasm that drove startup results in 2020 and 2021 has disappeared.
For many companies, near-term market changes aren’t a big deal. Some startups have enough cash to power through and will solve falling revenue multiples with sustained growth. Call it the Databricks strategy.
But for a good number of startups, the situation looks different. Here’s where some startups find themselves today:
- They raised a historically outsized round in 2020/2021 at a high price thanks to the market being flush with speculative capital.
- They spent heavily on hiring and growth goals, leading to stiff burn rates through the end of 2021.
This isn’t that bad of a situation, provided that the startups we’re talking about have enough cash to get through 2022. By then perhaps valuations for tech companies may have recovered somewhat. But with companies raising faster than ever before last year — sometimes three times in a single year!– some startups lashed themselves to growth targets that were inherently cash-consumptive. This means that many 2020 and 2021 raises won’t get companies through this full year.
That means they have to raise again, timing be damned.
So, some upstart tech companies now find themselves looking at the following two options: grow more slowly, saving cash, or keep the pedal to the floor at the expense of cash. What’s tricky is that neither option may work out for them. How so?
- Startups that raised at high prices with the expectation of rapid growth that are now facing a potential next-round valuation that doesn’t match their expectations can limit growth to conserve cash. This would provide a longer runway to their next funding round. However, this will harm their growth rates, leading to a far lower value attached to their equity, limiting fundraising options and bringing into question their long-term viability.
- Startups that raised at high prices with the expectation of rapid growth that are now facing a potential next-round valuation that doesn’t match their expectations could keep spending to grow, limiting their cash balance. This would lower their cash runway, but keep their growth rate comparatively high. However, with investors signaling that profitability matters, simply spending to grow might wind up a Faustian bargain.
This is the startup growth paradox. It is solved by going back in time and taking on capital at lower prices, or perhaps with a more limited growth plan. However, given that last year was a record for startup fundraising in terms of volume and prices, it’s a bit late for that.
Precisely how startups will handle this challenge will probably be a key narrative in 2022.
There are some ameliorating factors. Investors could fund their existing portfolio companies with extension rounds at flat prices. That would be dilutive to startups, but far from lethal. And startups can leverage some methods of growth that are less expensive — product-led growth, etc. — in hopes of managing good revenue expansion without terrifying operating losses.
But such forms of growth are not easy to pursue, even for companies built with such go-to-market methods in mind from day one. How to pivot from other sales methods isn’t clear for startups that may suddenly want to find a way to attract new top-line without hiring more sales staff or spending more on advertising.
Sorry for all the bad news lately, but consider it the tonic to last year’s party. This is the hangover.