Surviving the Funding Winter: Startup Valuations, Exits, and Governance in the Time of Rising Interest Rates

The 2008 crash instigated a significant shift in the global economy as the US Federal Reserve adjusted interest rates. The Federal Funds Rate dropped from 5.25% in 2006 to an unprecedented 0-0.25% range by the end of 2008. Given America's substantial influence on the world economy, this adjustment affected other central banks and their responses to the economic shifts, leading to a ripple effect on worldwide interest rates. As a result, cash became readily available.

This lower interest rate drastically influenced investments and individuals' motivations. Capital allocators that previously invested their money into interest-yielding bonds and credit redirected their capital, contributing to a surge in private equity, and consequently, venture capital. Private equity investments rose from $305 billion in 2006 to $681 billion in 2015, according to the Private Equity Growth Capital Council.

The abundance of cash made becoming a venture capitalist or a startup founder an appealing option. Many individuals transitioned from salaried employment to riskier ventures due to the available capital. They became fund managers, VCs, or startup founders. The influx of readily available cash led to differing views on company valuation, governance, and capital allocation. Startups could raise multiple funding rounds due to the abundance of capital seeking investment opportunities. This environment led to the emergence of pre-rounds and the proliferation of venture studios and startup studios, expanding the venture industry significantly.

It was the best of times and the worst of times. The valuation standards changed dramatically, with people starting to raise seed rounds of up to tens of millions of dollars based merely on a business plan. Exits and M&A became commonplace, and unicorns were no longer a rarity. Between 2013 and 2018, the number of unicorns in the U.S. increased from 38 to 156, according to CB Insights. VC fund managers were expected to model unicorns in their portfolio and then return funds. However, this period of financial frivolity led some industry participants to raise alarms about an impending crash. Although many dismissed these cautionary voices as Cassandras, their warnings had a basis.

The music eventually stopped, but not abruptly. There's been a continued rise in the benchmark for short-term interest rates worldwide, signalling a sustained shift in monetary policy. This trend indicates that capital is becoming increasingly expensive, impacting various aspects of the economy including startup valuation and investment strategies. Its effect began at the exit end of the conveyor belt with a crash in tech IPOs that significantly affected growth stage startup valuation. The average first-day returns for tech IPOs fell from 41% in 2000 to just 36% in 2021. The number of tech IPOs significantly decreased from 372 in 2008 to 188 in 2022. This downturn took a while to cascade down. Many founders who had raised money during favourable times now faced difficulties while seeking follow-on funding. Their companies had been overvalued at the seed level, and they now faced a harsh correction at the series A stage.

I've been in a lot of déjà vu conversations on this topic lately. Most of them are with founders, some of whom are part of our portfolio at Ventures Platform and have previously raised capital. They've made considerable progress and are now looking to raise more funds to sustain their growth. These discussions often circle around the same issues, albeit in different contexts. I think it's important to write down my thoughts. This can encourage broader discussions. It can benefit others who I might not be able to talk to about this.

A while back, I jotted down a few thoughts on how startups can structure their fundraise during this funding winter. These are additional insights based on those initial thoughts. Now, if there's one piece of advice I can give, it's this - if you can avoid fundraising, do so. But if you can't, this is for you.

Every fund manager and startup founder who raised money in the last five years did so in the good old days of zero-interest rates. Those days are gone. Interest rates have risen. Capital has become more expensive. This shift is having a profound impact on both public and private capital allocators, and startups are feeling the brunt of it. The result? A trifecta of implications - valuation, governance, and exit expectations.

Valuation is an opinion

A startup is premised on a future promise - that the entity will grow and capture value fast enough to justify its current valuation for the next buyer. There was a time when you could enter the market with a high valuation because there were enough big spenders that would pay for each milestone. But times have changed. Capital is no longer cheap, and big spenders can put their money in safer bets with decent yields. Consequently, many startups that raised pre-series A rounds before 2022 now have entry valuations that are out of sync with the current market. Yesterday's price is not today's price.

Here's a reality check. If your revenue has tripled, don't assume your valuation will too. Don't obsess over your previous valuation. Instead, figure out the maximum dilution you're willing to accept and the minimum amount of capital required to sustainably reach the next milestone. A lot of good companies are raising at a flat round. Remember, your exit valuation is what truly counts. All other valuations along the way are just paper opinions. The key question is whether you need to raise funds now. If you don't, then don't.

The stories of Dropbox and Box, two big players in the cloud storage industry, are quite illustrative of this point. Both started around the same time, but their fundraising journeys have been quite different.

Dropbox, co-founded by Drew Houston and Arash Ferdowsi, remained largely bootstrapped in its early years, focusing on organic growth and profitability before seeking significant venture capital. This approach allowed Dropbox to maintain control over its dilution and valuation, even as its user base and revenue grew. When they eventually went for a massive fundraising round, they did so with substantial leverage, resulting in a higher valuation. At their IPO in 2018, despite a challenging market, Dropbox was valued at approximately $9.2 billion. Drew Houston owned 25.3% of the company at the time of the IPO, demonstrating the importance of maintaining control over your startup's financial narrative.

On the other hand, Box, co-founded by Aaron Levie and Dylan Smith, took a more aggressive approach to fundraising right from the start. They sought and secured significant venture capital early, resulting in high entry valuations. However, this approach also led to substantial dilution and set high expectations for future growth. When market conditions changed, Box found it challenging to justify their valuation. Their IPO in 2015 resulted in a valuation of around $1.67 billion, significantly lower than their $2.4 billion private valuation. At the time of the IPO, Aaron Levie's stake was estimated at around 5.7%.

The key takeaway from these two examples is that obsessing over high entry valuations can lead to challenging situations down the line and significant dilution of founders' stakes. Instead, founders should focus on sustainable growth, controlling dilution, and securing the minimum required capital to reach the next milestone. Remember, your exit valuation is what truly counts.

The exit door is hard to find

The frost of the funding winter can be observed through the frequency and size of startup exit transactions. Tech startups in the 2021 IPO Class experienced the first impact when they saw a 60% average drop in their initial public market valuation. The repercussions were soon felt by tech startups anticipating private sales. Term sheets were pulled, sale prices were renegotiated, and some M&A deals entirely fell through.

Companies that once had plenty of cash for acquisitions are now tightening their belts. The public market is also feeling the heat. Recent tech companies' IPOs haven't performed well, and companies preparing for IPO have had to accept significant reductions in expected valuation, as seen with Stripe. These factors inevitably impact return expectations for fund managers and the way they model fund economics.

Everyone is now coming to the reality that unicorns are hard to find and retain. Fund managers are recalibrating the exit expectations of their portfolio companies. The previous strategy of basing seed fund returns on one or two 'unicorn' companies isn't prudent anymore. To return the fund, VCs are now modelling upside at low hundreds of millions for a higher number of companies in their portfolios rather than betting the house one or two outliers. This changes the profile of companies they invest in, the timing of those investments, and the expectations on how those companies need to allocate capital to meet their milestones.

There are two interconnected implications: capital efficiency and exit expectations.

Founders should adopt an investor's mindset by asking key questions: What is the optimal return I'm aiming for? How can I best allocate resources to achieve it? The answer to the first question is personal, largely depending on what you consider a life-changing or impactful financial outcome. For some, it's tens of millions of dollars; for others, it's in the hundreds. But regardless of your goal, you must align it with the timeline and resources available to reach it. The response to the second question is business-oriented. It is shaped by market timing, the business model, competitive pressure, and your execution capability. The first three factors are less within your control compared to the last, which requires the ability to maximise every dollar and minimise reliance on fundraising for growth.

Capital efficiency doesn't contradict growth and scale. It is feasible to balance profitability and growth concurrently. This requires a radical shift from the prevailing 'grow fast and break things' mindset that characterised the zero-interest capital days. It necessitates a strong focus on positive unit economics, revenue retention, gross margin expansion, expense optimization, and stage-appropriate hiring and compensation.

There are various paths to startup exits, each with its own potential pitfalls. All founders consider themselves outliers, a positive trait. However, those who manage capital efficiently and rely less on multiple rounds of fundraising for growth likely have a greater potential for successful exits. Additionally, most investors tend to view companies less favourably if the founders hold less than 50% equity pre-Series A.

Another significant advantage of capital efficiency is the liquidity of options. Semil Shah's recent perspective on the FTC's ruling regarding the Adobe/Figma merger highlights a crucial takeaway. Startups may need to go all the way to an IPO, which often necessitates subjecting their business to public pricing pressures for a longer period. This typically values them at lower multiples compared to strategic mergers and acquisitions.

Governance is making a comeback

One clear casualty of zero-interest days is the startup founder's perception of corporate governance. Many startups often overlook governance during their early stages. It's not uncommon for companies that have raised substantial funds to lack a board, budget, financial audit, or a finance control. While this might not be a major issue in the pre-product market fit stage, it becomes a significant handicap as these startups raise considerable funds at the seed stage and remain in this phase for an extended period before transitioning to Series A.

Founders who previously held negative views on governance, particularly with respect to boards, are realising its importance in maintaining accountability, especially as the startup grows and stakes increase. Similarly, startups are now getting compelled to consider raising a priced round, particularly when the amount raised exceeds a certain threshold.

The days when two founders could single-handedly control investors' money without any form of accountability are ending. This cultural shift requires founders to develop a stronger sense of governance.

However, governance is a double-edged sword. Too much of it can stifle the innovation and flexibility that founders thrive on, while a lack of it can exclude them from significant funding needed to scale. The balance depends on factors like company stage, team dynamics, founders' temperament, and the amount of capital at risk.I believe 2024 will be an intriguing year for startups, particularly those needing to raise capital. The scrutiny will become steeper, and due diligence will be more prolonged and demanding. Having the best product or traction will no longer be enough. Raising capital will require founders to be realistic about valuation, strategic about exit plans, and intentional about governance.

Thank you to all the founders whose conversations provided the fodder for this.

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