The Current State of the Startup Funding Market
People across the venture capital world are suddenly a lot more cautious about their money. The tech world is getting hit especially hard, with slashed valuations and massive layoffs everywhere. What does this mean for new startups trying to raise money? And what can you expect for the future?
What we’re seeing right now is the fallout from an explosion of speculation. The market is correcting after years of inflated valuations, and it’s going to be tougher to fundraise for a while. But if you’re still in the seed or pre-seed stage, you don’t need to worry as much. The crunch will be biggest for the companies that got bloated during the bubble.
We’ll give you some advice about fundraising in this new environment. Spoiler alert: it’s not much different from what we’ve been saying all along. A focus on your fundamentals and an eye for the long game will help you weather this storm. See below to find out how.
We’ve Been in a Feeding Frenzy
If you entered the startup world in 2018 or so, you might have a skewed perspective on what’s normal. Investors have been slinging around a frankly insane amount of money in recent years. Want the entertaining funny video version? Jake Hare, Founder of Launchpeer breaks it down in this hilariously true TikTok video.
What’s a typical valuation cap for a pre-seed tech startup? If you take the long view, it’s somewhere in the neighborhood of 1-3 million. That’s assuming they have an exciting idea and they’re targeting a pretty sizeable market.
In 2021, companies like that were getting valuations of 10-15 million. A few extreme examples went as high as 20 or 30. Remember, we’re talking about startups that hadn’t actually built any product or generated any revenue.
How could venture capitalists justify making those bets on such an unproven company? Basically, because everyone else was doing it. You hardly had to worry about startups failing, because they could look forward to an even bigger valuation in their next funding round. And obviously, it didn’t hurt that the economy as a whole was doing well.
In other words, the past few years of the VC market have been one big orgy of market speculation. That pushed startup valuations way higher than their financials warranted.
The Pendulum is Swinging Back
But in the past few months, a few big shifts have made VCs much less confident. There’s rising inflation. Supply chain issues keep getting worse. And Russia’s invasion of Ukraine has thrown a ton of uncertainty into the global energy market. All of a sudden, a huge speculative investment in a pre-revenue company doesn’t seem like such a safe bet.
So the capital is drying up. That’s bad news for the startups that were swimming in all that investment money. If they want to raise money, they have to settle for a down round at a much lower valuation. And that sends a very bad signal to other investors. Sometimes it can trigger a race to the bottom that completely tanks the stock price.
A common alternative is for investors to put heavy conditions on their next funding round. They’ll tell founders that they have to meet robust profitability targets to keep their high valuations.
That’s a tough ask for startups that have spent years pursuing growth while putting off revenue. Often, they can only meet those targets by cutting costs. That usually means layoffs. So if you wondered why the past month has been such a bloodbath for tech jobs…now you know.
There’s an element of unfairness in all this. In many cases, investors were pushing these companies to ignore revenue and chase growth at all costs. Now they’re turning around and asking for financial responsibility. So startups and tech workers get punished for the VC’s wild bets. Unfortunately, that’s often the reality of the market.
Better News for the New Kids
We’ve just painted a pretty bleak picture. However, you’ll notice we were talking about the startups that got huge by guzzling all that easy money. If you have a small startup in the seed or pre-seed phase, you don’t need to worry as much.
That’s partly because you don’t have as far to fall. If you’re not funded yet, you don’t have to scramble to keep your runway. And if you’re not pegged to a crazy over-valuation, you don’t have to be concerned about a down round.
If anything, smaller companies that aren’t seeking huge valuations look much better to investors right now. Your stock price hasn’t been driven up by a five-year speculative bidding war.
Keep Your Eye on the Numbers
The moral of this story is to anchor your fundraising goals with data. Don’t try to shoot for the highest valuation you can get. And always have a roadmap to profitability. You can’t count on investor cash to keep you afloat while you grow.
This is why we emphasize validating your business model in the marketplace before going to VCs. Buy some ads or make some cold calls. Figure out how to get your sales costs lower than your customer lifetime value. Then look for funding to help you scale up.
What if you really can’t build your product without some venture capital? In that case, set your valuation based on what you need, not how much you think you can get. Calculate what it will cost to get your company off the ground, then negotiate for a valuation that gets you that amount.
Play the Long Game
The capital market looks intimidating right now. But one crucial takeaway from this post is: don’t focus so much on market fluctuations. Yes, you need to adapt to economic conditions as they shift. However, when you’re thinking about what your company is worth, think long-term.
If all goes well, you’ll probably be running your startup for at least the next 5-10 years. The market is going to go through some fluctuations in that time. It’s inevitable. In fact, this exact cycle of inflating valuations followed by a crunch will probably happen again in another decade or so.
That’s why you should plan based on hard numbers like customer acquisition cost and lifetime value. If you count on the market to keep doing what it’s doing, it will disappoint you sooner or later.
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The Bottom Line
Capital is going to be tighter for at least the next year or two, and maybe longer. That shouldn’t intimidate you if you’re still running a young, scrappy startup. And it shouldn’t change your basic strategy. Get your fundamentals right before you go chasing capital.