While the last decade has been a bull market for tech companies, 2021 was exceptionally good; 2021 saw the creation of 959 unicorns (1B+ valuation) total, a 69% YoY jump from 2020. 2021 was also a record year for funding with 621B in funding, up 111% YoY. In 2022, however, public stocks saw a dramatic reversal. The S&P fell by over 20%, and the tech-heavy Nasdaq fell by over 30% as of June. Total funding for Q2 was 108.5B, down 23% QoQ, and total exits dropped to 2,648, a 16% drop from Q4 2021.
As public markets edge toward bear territory, several prominent venture capital firms have issued stern warnings to portfolio companies, telling them that the current economic downtown signals trouble ahead.
How did we get here?
When Covid-19 hit in 2020, global economies grinded to a halt. Many people were stranded at home, leading businesses to either have their employees working from home or shut down altogether. To offset the effects of the pandemic, governments poured in trillions of dollars into the economy. This measure worked, and the economy was able to perform a V-shaped recovery. However, this led to inflation rising to the highest levels since 1981.
Inflation, combined with the war in Ukraine, rising interest rates, and worries of a looming recession have been pushing the equities market down. Tech stocks in particular were hit hard, with the Nasdaq dropping more than 30% as of June. This is in sharp contrast to 2021 when record amounts of funding poured into startups and valuations hit all time highs.
What does this mean for startups?
Given that many VCs are pulling back on investments, there is less money to go around, which may cause problems for companies looking to raise funds in the near future. Companies that do raise money are doing so at the peak of a downturn, given that valuation metrics are not what they used to be. Startups need to consider options they wouldn’t have under normal circumstances, including a flat or even down round. An extreme example of this is Klarna whose valuation plunged from $45.6B to $6.5B.
Many VCs will adopt a more conservative approach when investing by spending more time on due diligence. They will be setting and monitoring KPIs and milestones more carefully. This was previously not the case as deals were closing at record speeds on account of VCs fearing missing out on hot investments. This meant a lot of VCs blazed through due diligence just to be on the cap table. With the new conservative approach, rounds will likely take longer to close.
There will also be less interest in growth at all costs. VCs will want a return to fundamentals, including more emphasis on hitting financial numbers and a sharper focus on revenue growth. This is in sharp contrast to 2021 when hyper growth was rewarded; investors are looking for sustainable companies with a clear path to profitability.
So what can startups do?
For startups, all focus should be on extending the runway and planning for the worst. A good place to start is to scale back hiring, for now. Reducing expenditures like travel and M&E will also help. If there are new products in R&D or projects not contributing to the core business, this is a good time to focus those efforts and resources elsewhere. Customers will also be impacted by these events. If startups can pivot and create something that addresses their current needs, the demand for their product may spike.
If there are contracts or leases coming up for renewals, this is a good time to ask for better pricing and payment terms. Venture debt may also be a viable option to extend runways. Startups should aim to extend the runway for at least 24 months.
Some good news
Many consider this tech reset long overdue, including the Japanese conglomerate Softbank. This is because 2021 saw records set for funding and valuation with VCs rushing to close deals. The Klarna valuation is a good example of the market correcting. And although the current circumstances are challenging for startups, it also brings lots of opportunity. Some of the biggest names in tech like Uber, Airbnb, and Square (now Block) were built and thrived after the 2008 downturn. Changing economic conditions bring with them all kinds of problems for startups to solve. These changing conditions can help companies evolve in ways that were never previously envisioned. Another benefit to economic changes is that competition may be reduced or weakened, allowing startups to gain market share. Investors have toned down growth expectations, which means for the time being, founders can focus their efforts elsewhere. Funding wise, the tides may be shifting. July was a hot month in the US, bringing the 2022 total to 137.5B compared to 142.1B for 2021. It’s unclear whether this trend will continue Q3 onward.
The companies that are able to navigate this downtown will thrive once the markets stabilize. The road ahead will not be easy, with many difficult decisions needing to be made. The key is to stay focused on business fundamentals and be ready to adapt to changing market conditions.
“It’s what you do right now that makes a difference.” Jeff Struecker, Black Hawk Down