Defying the Downturn: Navigating the Funding Environment

       

     Key Takeaways

• Unlike the dotcom bust and the 2008 financial crisis, the current downturn is driven by multiple factors like inflation, geopolitical risk, and market turbulence.
• Record levels of dry powder and signals of resilience mean there is still opportunity for businesses with strong fundamentals.
• A focus on Team, Traction and Technology can help when positioning an early-stage start-up to investors.

 

The current market downturn is likely to be the first that many technology start-ups have faced. This content series explores everything from fundraising to maintaining a culture as you ready your business for challenging conditions. 

What’s the investment market like for tech start-ups right now?

The answer might seem obvious. There has been widespread news coverage about plunging tech company valuations, a slowdown in funding, a likely recession in some economies, and mass job cuts – albeit mainly among larger, more established tech companies.

Look closer, however, and there are signs of real resilience.

Despite the downturn, investment figures are still relatively close to the record-highs of 2021¹  and venture capital investment in early-stage start-ups remains buoyant.

And let’s not forget that historically, downturns have seen entrepreneurs start some of the great, innovative businesses we see today. This could be down to the need to be creative in trying times, but there’s a practical consideration too. With many start-ups cutting costs by pressing pause on hiring, and potentially reducing their workforce, the overall opportunity cost to start a business also drops.

All this means that, even in difficult circumstances, high-quality businesses can still attract investment and find success – if they are equipped to navigate the evolving funding environment.

      A Downturn with a Difference

To navigate the new funding environment, it’s important to understand how it differs from previous downturns.

Stock markets reacted to the bearish influences seen in 2022 as you would expect: in the third quarter of last year, funding for European start-ups fell by more than one third (36%) from the previous quarter to $14.8 billion2.

This is a direct response to heightened uncertainty, which is a significant driver of the lack of appetite for investment.

In uncertain times, investors’ natural response is caution because it is more difficult to take the long view: rising inflation affects the way VCs value their investments, while stock market turbulence makes exit valuations harder to predict.

Of course, uncertainty itself isn’t new, and neither are economic downturns. What is different is that this time there is a combination of negative economic and geopolitical factors to consider, where historically there has typically been a single force at play.

The 2000-2001 dotcom bust was about companies having insupportably high valuations, using very bullish metrics. The financial crash of 2008 was the result of systemic risk from over-leveraged banks.

The current environment is a combination of material factors. This situation is quite unique; for example, we have not had comparable inflation since the early ‘80s, and certainly not alongside significant geopolitical risk, historically high growth-stock valuations, and market turbulence.

But it’s not all bad news.

    Resilience and Record Levels of Dry Powder

Despite the unique nature of this downturn, there are some encouraging signs, especially for early-stage businesses (meaning they have not yet secured a Series A funding round).

For example, US venture capital (VC) fundraising is on track to have a record year and US VC investment its second–best year. Early-stage activity is robust, with 5,350 US VC deals in the first half alone − in line with 2021’s record year³.

This suggests that, although they are more cautious, investors are still eager to invest in high-quality businesses.

Another positive sign is the record high level of “dry powder” − capital waiting to be deployed − across the innovation economy⁴.



It is a case of “when” and not “if” this funding will be deployed across the market. Here are three things you can do to ensure you are ready to access this funding when it becomes available.

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#1: Focus on Fundamentals

With investors on a “flight to quality”, a renewed focus on business and financial fundamentals is essential.

This looks different depending on the maturity of your business. Where start-ups would typically invest in growth, later stage companies are more likely to pivot towards profitability.

In 2021, and for the first half of 2022, investors were prioritising growth rather than profit, among other factors. While rapid growth is still a priority for start-ups, there is now an increased emphasis on financial discipline. This sentiment is echoed at the later stages, where there is greater focus on unit economics and capital efficiency.

In that context, it’s crucial that founders account for every dollar invested to reassure investors about the long-term prospects of the business; after all, investors are also taking a disciplined approach.

This renewed rigour is evident in due diligence timeframes. In 2020 and 2021, VCs could spend as little as a few days doing due diligence on a tech start-up before investing, which was highly unusual. Today, founders can expect the process to take weeks or months – largely due to a focus on the timeless fundamentals of Team, Traction and Technology – let's call these “the 3 Ts”.

#2: Think about "the 3 T's" - Team, Traction and Technology 

Who are the key people in the Team? What have they done before? Are they serial entrepreneurs? Did they previously work for a big start-up, such as Uber or Netflix, or in another, super high-growth environment? All are key considerations for founders and investors alike.

But entrepreneurial experience isn’t everything. Founders with good ideas but little track record can still succeed if they get the right people involved in their company and build the right team.

The Technology itself also needs to exhibit the potential to endure. Questions investors could ask may include:

• Is it defensible?
• Can they evidence robust Product-Market fit?
• Is there any protected Intellectual Property (IP) creating a barrier to competitive threat?

Last, and in many ways evidencing the effectiveness of Team and Technology, is Traction.

To convince VCs your business can succeed at scale, you need to show you can deliver market-leading growth rates. If you’re going to be a unicorn of the future, after all, you had better be growing quickly in your early days.

Evidencing the long-term potential of the business with growth data is essential. Usually this means showcasing possible revenue growth. Remember, VCs may have a positive bias towards recurring revenues, but could include other growth metrics (daily user growth on a social network, for example).

#3: Positioning a Down Round

Selling shares to raise money at a lower price than previous financing rounds is a financial – and most likely an emotional - hurdle for most founders, but it may be a necessity in the current climate.

Founders in need of cash will often have no choice, as these funds will be used to increase runway, strengthen the finances of a start-up, build a product, and market it.

However, with investors now requiring start-ups to have more runway – between 24 and 30 months – it is essential to show exactly how you will use this investment to build a better business.

For more mature businesses, a down round may be the cash that keeps a business operating until it is ready for another funding round, but it is still important to account for every penny spent.

Remember, a down round is often a reflection of the economic climate and not only your business. In fact, it may suit repeat investors, who may not be too concerned as they’re buying a share of your company at a lower price.

    Obstacles Often Reveal Opportunity

For many start-ups and investors, this tech downturn will require a return to doing the basics brilliantly.

But that does not mean there is not opportunity on offer.

Founders who overcome greater diligence, selectivity, and down rounds can benefit from record levels of dry powder, smaller cheque sizes and longer investment horizons – a set of parameters that suits early-stage founders and investors alike.

As seasoned entrepreneurs and investors well know, economic crises often drive technological innovation. It’s all about building a business with strong fundamentals so that you can not only survive today, but thrive in the long term.

Want to talk about the path ahead for your business? Reach out to Greg Brown or Alex Threipland.