Early-stage enterprises must show a robust sales model and revenue retention to attract investors.
When Christina Ross, CEO of Cube, started trying to raise money for her new financial planning software company in February, cloud stocks were already down 40% from their highs in 2021.Over the next few months, they had to fall a lot more.
By the time Cube announced its $30 million Series B deal in the middle of June, the broader market was about to end its worst first half in 50 years. This was led by a drop in high-growth tech stocks, which had been the best performers in the Nasdaq Composite’s rise to a record in November.
The private financing market tends to lag behind public stocks, giving venture investors time to adjust their expectations for possible exit prices.
But the change is now full-fledged.
Since the IPO market shut down, pre-IPO rounds have pretty much stopped, and the sharp drop in software multiples has stopped private deal flows. Companies are doing everything they can to avoid a “down round,” which is a funding round that gives them less money than their last round.
Ross started Cube in 2018, and he knew that any valuation today would be a long way from what it was worth in 2020 and 2021. But she also knew that a lot of these expensive deals turned out to be a burden for the people who got them. They now have to deal with a new, bad situation.
“There was a reset,” Ross said, but she wouldn’t say anything else about her deal, including how much it was worth.
“We just got lucky that we didn’t get caught up in what happened last year.”
The National Venture Capital Association says that the number of financings of startups worth $1 billion or more almost tripled last year to more than 600, and the amount invested in these deals rose from $52.7 billion in 2020 to $140.8 billion in 2018. Ross points out that some companies with annual sales of $10 million were being valued at $1 billion, which is 100 times their annual sales.
Those times are long gone.
Investors ran away from the riskiest companies when the Fed raised interest rates quickly to stop inflation from reaching a 40-year high. They got rid of companies in particular that needed to keep getting money from the capital markets to stay in business.
The Wall Street Journal reported last week that the Swedish fintech company Klarna, which was worth $46 billion last year, is now trying to raise money at a $6.5 billion valuation. This comes after the share price of U.S. competitor Affirm fell by about 90% from its high point in November. A Klarna representative didn’t want to say anything.
In March, Instacart cut its own valuation by almost 40% and told people who wanted to join that they could get stock at a lower price if they did so. Oren Barzilai, CEO of EquityBee, said that deals are “getting done at better terms for investors” in the secondary markets, where employees and former employees of private companies sell some of their equity to get cash.
EquityBee connects startup workers with outside investors who are willing to write checks so that people can use their options, usually after they leave a company. In exchange, the investors want the right to a certain amount of the company’s equity if it goes public or is bought. Barzilai said that investors now often get 30% to 40% of the potential upside, whereas they only got 5% to 10% of the upside a year ago. Barzilai said, “The trends have changed.” “Companies that were very popular last year are not as popular as they once were.”
Late-stage companies trying to raise money usually have to do what Klarna did and accept a lower valuation, or they have to treat new investors very well and let them get their money back before anyone else, or make a higher return when they eventually sell the company.
“Protection from the bottom”
Startups usually go with the second option and accept what Wall Street calls “structure” in their financing deals.
Larry Aschebrook, managing partner at growth stage venture firm G Squared, said that his team won’t put money into any deal without “downside protection.”
“Depending on the underlying business, you might get a top-line number that is flat or up, but there are some built-in protections,” said Aschebrook, adding that his company’s level of cash deployment is about 60% lower than it was a year ago.
“Given how easy it was to get money in the last few years, very few businesses had any structure in their equity rounds.”
Cube is still in its early stages, so it isn’t as affected by the stock market.
Still, Ross had to answer questions this year that she didn’t have to answer when her company raised its $10 million Series A in early 2021.
For example, Ross said, investors are now asking if the company will have enough cash to last 36 months. In the past, they only wanted the cash to last 18 to 24 months.
Also, even for young companies with fast growth, making money is important.
Ross said, “The due diligence was a lot more in-depth, especially when it came to metrics that would never have come up before, like margins.”
Investors also asked about sales efficiency and net dollar retention, which is how much money customers keep and buy more of.
She said, “These aren’t even questions that were asked before.”
Christina Cacioppo is the CEO of the compliance and security software startup Vanta. She raised money in 2021 and took on another round of funding in May, which she called “a very different fundraising environment.”
Last year, when venture capitalists looked at Vanta, they were most interested in how much money the company was making.
Cacioppo said that in 2022, it was the burn multiple, a measurement that was explained in a blog post by one of Vanta’s backers, David Sacks of Craft Ventures.
The number shows how much a company has to spend to bring in one dollar of new recurring revenue.
“In this market, not many people want to give you money if you’re not growing well,” Cacioppo said.
In the last round, her company was worth $1.6 billion.
Due diligence is back
Investors often want to know what a company’s “magic number” is.
This calculation tells potential investors how long it will take for a company to get back every dollar it spends on sales and marketing. It does this by taking into account the growth of sales over time and how much it spends on sales and marketing.
The CEO of a new database company called SingleStore, Raj Verma, said that investors were very interested in these kinds of calculations as the company tried to get its latest round of funding, which will be announced later this month.
In September, Vanta raised $80 million.
Verma said that this time, investors wanted to know how long it takes for a sales rep to start making money, how many account executives there are compared to sales engineers, and how many salespeople helped meet an annualised recurring revenue goal.
He said that it costs 14 times more money to make money from a new customer than from one you already have. This makes the dollar-based net retention rate a more important number.
Verma said that it is “the one metric to which people bring thousand-watt bulbs.”
The bottom line for investors is that they want to be sure that the money they put in will last for a long time. The time when cash was cheap and easy to get is over. And they want to get in at a price that takes into account how the public market has changed.
Mike Volpi of Index Ventures said that deal activity has slowed down everywhere, but there is much more action in the early stages than in the growth equity market, where there is “very little liquidity.”
Volpi said that Series A rounds no longer give companies a value of $200 million, but they are still historically high, in the range of $50 million to $100 million, which is about where they were in 2018.
Also back is due diligence.
“Deals take a little longer to close now, which is good for both companies and VC firms,” said Volpi. “It gives us more time to think about an idea, talk to other people, and check references.
It helps the company find out which VC they really like.”
Volpi said that Index’s advice to the companies it owns is that they should change based on what their customers tell them. But if customers are still spending and the business has enough money to last for a few years, don’t change anything just because the market has shrunk.
He said, “We’re telling people to keep doing what they’re doing because the world will be different in two years.”
“If you see signs that your customers are changing, make changes. But if you don’t and you have money, don’t worry. While everyone else is freaking out, this is your chance to step up.