It’s Raining. Where is the VC Umbrella?

In the past decade, low interest rates and a lack of “real-return” alternatives led to excess cash flowing through venture capital, private equity, and growth equity funds—and a subsequent boom in private tech company valuations. 

Fast-forward to today. Inflation, rising interest rates, the war in Ukraine, lingering pandemic challenges, and mounting recession fears have culminated in VC’s first period of belt-tightening in many years. 

This cash crunch is sending shockwaves across the tech sector, and is particularly jarring to first-time entrepreneurs who have never operated in an industry where funding was hard to come by.

For many years, irresponsible funding—and resultant overspending—was the norm. VC funding was almost considered validation of a startup’s business model and carte blanche to invest in office spaces, perks, parties and short-sighted hiring plans. 

But as the tech industry cools, VCs are backing off. 

Swinging for the Fences in a Downturn

When the market is on a downward trajectory, VCs are not encouraged to offer down rounds or bridge loans as they don’t align with their investment criteria. That’s because VCs are biased. Their bias is to exit a certain proportion of their portfolio in order to make their investment model work. They typically need one startup in ten to exit at 10x or eight in ten to exit at 5x to make a return for their investors.

Instead of taking a mediocre exit, the VC is more likely to take a “swing-for-the-fences” approach. 

They will pressure the board to try aggressive tactics to grow their valuation and generally take risks that may result in bankruptcy within 12 months. For startups in a downward market with no access to more VC, the result is a shortened runway and mass layoffs and cost-cutting to shore up cash to survive as long as possible.

The Human Cost to Irresponsible Funding and Spending

After the outlandish, VC-fuelled spending we witnessed over the past few years, tech companies are rethinking their plans. They’re instituting hiring freezes, rescinding job offers, and making rounds of layoffs. 

It’s easy to reduce this to statistics in news articles but the human cost is high. Thousands of hard-working people with rent or mortgage obligations, families, and other financial burdens were laid off from public and private tech companies in the past few months alone. Here are just a few companies that hit the headlines for mass layoffs: 

• Unbounce
• Thinkific
• Hootsuite
• ThoughtExchange
• WealthSimple
• Robinhood
• Glossier
• Better
• Boosted Commerce
• Outbrain
• Shopify

What do these companies have in common? They’re all venture-backed.

Why Is This Happening?

For founders, there is a psychological difference between spending VC money and spending their own hard-earned money. When people are spending “free” money, they tend to be more careless with it than with money they’ve worked hard to earn. 

Case in point: approximately 35% of companies that get series A fail before their Series B round. A similar effect can be noted in the phenomenon that lottery winners are more likely to declare bankruptcy within three to five years than the average person. 

VC-backed startups are typically less capital efficient than their bootstrapped counterparts. This spendy culture gets them into difficult situations that have real impacts on people’s lives, like the mass layoffs we see today.

The New Normal

The new normal for technology financing means that investors will be more selective about the companies they invest in. Startups with poor unit economics and unrealistic growth strategies will find it a lot harder to access growth capital than in previous years. Is this really a bad thing? 

Companies that are creating value and being efficient with their capital will be rewarded with investment; companies that are not, won’t. 

Rule of 40

The Rule of 40, shared by Brad Feld, is a simple rule of thumb whereby growth rate plus profit should exceed 40%. 

According to Feld, Growth investors apply the Rule of 40 to companies with greater than $50M in revenue to quickly determine the attractiveness of a business.

• If you are growing at 20%, you should be generating a profit of at least 20%
• If you are growing at 30%, you should be generating a profit of at least 10%
• If you are growing at 40%, you should be generating a 0% profit or higher
•  If you are growing at 50%, you can lose 10%

Tom Tunguz analyzed Feld’s hypothesis and found that, in the early days of a company’s life, the median GP metric is substantially greater, often exceeding 100% and in the later stages of a company’s life the median decreases.

Source: Tom Tunguz

Regardless, the Rule of 40 is a good benchmark for companies in years five through eight. By focusing on this and other unit economics— customer acquisition costs, cash conversion cycles, customer payback, etc.—startups and investors alike can create a more sustainable standard in the industry than that set by VCs over the past decade.

Advice to Founders

Navigating the next few months or years as a startup executive may be tricky. But the industry has weathered storms before and good companies, with solid unit economics, typically come out stronger on the other side. 

Here are some avenues you can explore (or avoid) to make the journey a little easier:

1. Be aware of the true cost of capital—and the biases behind the providers (remember, VCs are biased toward one or two big exits and their advice may lead you to take a swing-for-the-fences approach your business may not survive) 
2. Consider the Rule of 40 and focus on your key metrics (churn, retention, expansion)
3. Explore and take advantage of government grants, tax incentives, hiring credits, etc. (In Canada, check out Pocketed, in CAN and US check out Boast.)
4. Consider taking a bridge loan from a senior lender rather than VC—as valuations continue to dip, debt will be a much cheaper option in the medium to long term
5. Look at non-dilutive growth capital from transparent providers like TIMIA Capital. Take a look at our offerings and browse our customer stories to see if we would be a good fit for your growth stage.

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