How Long Will the Startup Winter Last?

Welcome Shareholders,

Over the last few weeks, Every Sunday, we've highlighted one company to do an in-depth breakdown of their business, financial situation, and whether or not it's a worthy investment opportunity. This week, we're switching things up by zooming out to cover the current state of the venture market rather than covering a single company. So sit back, grab a snack, and enjoy!

In Many Ways, the current Startup Landscape is a vastly different operating environment compared to the one seen a year ago. The era of cheap and easy money is firmly over, as founders now need to compromise on valuation or provide investor-friendly protections to attract capital from cautious Venture Firms who have seen their previous investments decline rapidly. Investors have cautioned startups to be prudent with their spending to extend the runway as they anticipate a prolonged funding winter, while founders have somewhat been mixed in reacting to the sudden shift in tone from investors. Well-capitalized firms that recently raised money are continuing to spend, taking advantage of the misfortune of their competitors, while those less fortunate have had to go back to the drawing board to rework their model, fire employees, and pull back on spending to achieve profitability quickly.

Put simply, the situation is unlike anything seen in prior down cycles and could potentially make or break startups that have thrived in recent years. So how long will the Startup Winter Last, and how Severe are the operating conditions expected to be? Let's look at the data to understand the situation.

How Did We Get Here?

Before we talk about the current state of the startup ecosystem and where things are headed next, it's important to first circle in on how we got here in the first place. The startup landscape has drastically shifted over the last decade, with the number of private market investments and deals having exponentially grown, fuelled primarily by zero rates instituted during the great financial crisis. Startups with a growth-at-all-costs mindset were the primary beneficiaries of the venture boom, even if the underlying business had unfavorable unit economics or if the growth was unsustainable over the long term, all in the hopes that they would emerge as the next PayPal or Tesla. The search for yield increasingly blurred the lines between public and private market investors, with 'Tourist' investors, including corporate venture arms, hedge funds, and private equity firms rushing in to capture early-stage returns.

Crossover funds that invested in both public and private companies have surged in popularity in recent memory. In fact, crossover funds and tourist investors have widely been credited for driving up deal prices across the venture industry in recent years, with their participation reaching a record 78% of the total US deal value in 2021. Investors were incentivized to deploy capital rapidly and raise money for their next round, leaving little time for due diligence. Companies took advantage of the environment, often raising money once (or even twice ) a year, doubling & tripling their valuations in under a few years. There were more unicorns (billion-dollar companies) minted in the US in 2021 than in the five years preceding it (340 in 2021 vs. 296 between 2016-2020). However, things came crashing down in late November 2021 as a result of record-high inflation, tightening monetary policy from the federal reserve, and geopolitical Uncertainty.

Pandemic-era policies, including stimulus checks, record governmental spending, and zero rates, led to an explosion in consumer spending, a strong job market, and booming business. However, supply-side issues coupled with soaring demand would eventually lead to the worst inflation seen in over four decades. Central bankers who were asleep at the wheel vowed to combat rising prices by raising interest rates and reducing their balance sheets. The Fed, in its ambition to bring down inflation, may eventually cause a severe recession. It wasn't helpful that the Geopolitical Uncertainty caused by Russia's invasion of Ukraine led to an energy shortage across Europe and translated to higher inflation. Stock and Bond Markets, which caught on early, started plummeting from their record-high values. Technology and growth-focused stocks were especially hard hit and plunged between 70% and 80% from their pandemic highs.

The declining valuations have prompted companies to stay private for longer, instead opting to raise money through venture investors. After a stellar run which was marked by multi-billion dollar IPO and Special Purpose Acquisition Corp (SPAC) activity, new issues plunged in the second half of 2022. The dry-up in IPOs gives little room for private investors to plan their exits and capitalize on their initial investments, thus prompting companies to opt for lower valuations to get new funding. The fear in public markets thus eventually spread to pre-IPO late-stage startups. These included payments firm Stripe, Buy Now Pay Later company Klarna, and Delivery startup Instacart, which slashed valuations by between 20% and 70% to reflect the prevailing sentiment, opting to raise money through a down round. With Venture and crossover funds now marking down their public and private market investors, the contagion spread to early-stage investors, who have become more cautious in their funding deployment, leading to a cut in valuation across the board.

How Long will the Startup Winter Last?

Broadly speaking, there are two main factors that could determine how quickly the venture capital and startup ecosystem could rebound to the record highs seen in 2021. These include

• The clarity for both venture firms and other investors on the macroeconomic situation, risks associated with current geopolitical uncertainties in Europe, Inflation in the US, and aggressive tightening from central banks around the world.

• The ever-evolving Startup-Venture funding dynamics - The shift in the balance of power from founders to investors, and if founders are willing to take less favorable terms to stay alive.

First and most importantly, venture firms and other market participants will look for clarity in terms of the broader macroeconomic uncertainties, including the Federal Reserve's interest rate policies, the current inflation, and other geopolitical shocks causing supply-side issues. In a bid to combat inflation, the Federal Reserve has raised the benchmark interest rates by 450 basis points to 4.75% over eight meetings. Market Participants are now forecasting that the Federal funds rate to be close to 5.25% by the middle of this year, thereafter which the central bank will supposedly 'pivot' cutting rates to 4.06% by the end of 2024 and slowly bring rates down to 3.43% by the end of 2027. Time will tell if the Fed decides to pivot in the face of deteriorating conditions (as it did so in the previous cycles in 2001, 2009, and 2018) or if it will take a more aggressive approach similar to that of the Fed's actions in the 1980s. The former could result in a strong market bounceback similar to the one seen in 2018, while the latter could induce a severe recession that could be unfavorable for businesses for at least a few years. From this, we can see that the downturn could last anywhere from 12 months (in the most favorable scenario) to more than 60 months (in the worst case).

In addition to the Macroeconomic factors, structural changes in the startup ecosystem could further help paint a picture of the length and Severity of the downturn. The key factor that will determine this will be the willingness of founders to accept less favorable terms when raising money compared to last year. Funding dynamics have rapidly shifted over the past year from founder-friendly investors rushing to close deals previously to one that's similar to traditional venture investments, where the terms and protections are more geared towards investors. The areas where investors could get better terms include three areas: valuation, funding terms, and due diligence. The headlines are clear, which suggests that valuations will decline across the board, at least compared to the mania seen over the last two years. Investors ranging from SoftBank to Tiger Global and Lightspeed have warned founders that the startup winter could last longer if founders are unwilling to cut valuations. Valuation cuts of 30% to 50% across industries are the new norm, and private market valuations now reflect average public comparable multiples (at least in growth and late-stage deals).

Another factor to consider is the funding terms, ranging from preferential treatment to new investors or higher returns in an eventual exit event. Late-stage investors are now typically demanding between 30% to 40% of the potential upside in case of an exit event, compared to between 5 to 10% a year ago. In addition, investors are demanding preferential exits over existing investors and downside protection in the form of anti-dilution clauses and ratchets. Finally, Venture firms are also ramping up their diligence efforts, resulting in more time spent closing a round than before. While investors would have previously looked at growth-focused metrics, they are now focused more on survivability. This includes looking at profitability metrics, including cash at hand, margins, burn multiple, sales efficiency, and net retention rate.

A Quick Look at History

To understand how long it would take for the startup ecosystem to recover to the levels seen in 2020 and 2021, it is important to look at the previous boom and bust cycles of 2001 and 2008. Both cycles resulted in structural changes for both startups and venture firms but varied based on the Severity and length of impact. The crash in 2008 was bought about by a global financial crisis primarily driven by the housing market, while the downturn in 2001 was primarily related to tech. The former saw a V-shaped recovery, with the Nasdaq recouping its October 2007 highs four years later in April 2011, but on the other hand, the dot com burst had lingering effects that lasted over a decade. The Nasdaq hit its high in March 2000 but did not trade at these levels until 2014. More importantly, the Severity of the downturn was also higher during the dot-com burst compared to the great financial crisis, with the failure rate being higher.

Several factors contributed to the crash in 2001, not too dissimilar to the current landscape, including rising interest rates, soaring valuations, and the lack of a viable business model. However, one could say that the current market conditions are a combination of the previous downturns. Some areas of the market, such as Special Purpose Acquisition Corp (SPACs), Crypto, Fintech, and ESG-focused investments, defied fundamentals for a brief period, similar to technology stocks in the dot-com era, before plummeting. Other areas of the market mirror the mania of 2007, where low-interest rates have sparked higher venture investments and a strong housing market. Both these areas are now seeing a severe correction as the Fed continues to raise rates and tighten its balance sheet.

One area where the Startup landscape differs from the previous down cycles is the ability of founders to secure a favorable exit before the crash. The Dot-com era and the Great Financial Crisis were both preceded by robust IPOs, with public market investors eating the brunt of the losses that came a few years later. In comparison, IPO and SPAC activity as a percentage of private investments has been lower. As mentioned earlier, Startups have been staying private longer (4 years in 2000 vs. 12 years now), while late-stage investors have consistently made more than IPO investors (around 9x). While returns were favorable before the slowdown, venture funds, private equity investors, and crossover funds will now likely face the majority of losses through markdowns in their investments.

The Great Reset

While Startups and Venture Firms will undoubtedly bounce back sooner or later, the landscape could look very different, with both founders and investors learning hard lessons from the current downturn.

'Founder Friendly' investors who have only seen a bull market are now having their first difficult conversations with founders and CEOs. Tourist investors and Fast-moving VCs who wanted to previously disrupt venture capital are now watching their investments shrink by between 30-70% in less than a year, which is wiping out decades of compounded gains. This is sure to impact their investment philosophy moving forward, making them more cautious about deploying funds to new companies while negotiating tougher terms for existing investors. Some may even look to revert back to traditional capital allocation in public markets, where information asymmetry isn't a problem and due diligence is much easier. These Investors have previously looked at key metrics like growth, gross merchandise value (GMV), market share, and turnover over the past ten years but are now adjusting their expectations to reflect the current market conditions.

This includes looking to unit-level profitability, a focus on sustainable growth, burn rate, and time to break even. Another investor phenomenon in recent years that will likely come to an end is the rise of 'ghost VCs,' who have aided startups in raising capital but have neglected much of the other functions and responsibilities that come with making investments. These investors have typically stopped attending board meetings and returning calls from founders looking for advice. While this likely worked due to pandemic restrictions and easy operating conditions, the return to in-person work, coupled with founders demanding more from their investors, will separate the best venture firms from the rest.

Startups that have shaped their business model with a focus on growth at all costs will see more pain than those that have a path to profitability. Previous startup winters have resulted in many companies shelving expansion plans, conducting mass layoffs, and either being acquired by well-capitalized firms in the industry or eventually declaring bankruptcy. What could make this cycle more severe is that both investors and startups have been caught off guard by the rapid change in the market dynamics. Unicorns and Late stage startups, who have positioned themselves to capture the rebound in demand from the pandemic, eventually hoping to get access to more liquidity through an IPO, will have to return to the drawing board to find ways to stay alive. As YCombinator co-founder Paul Graham suggested back in 2015, startups will need to evaluate if they are default alive or dead.

Essentially, startups will need to evaluate if they have enough cash in the bank to survive until they attain profitability. Let us look at an example to understand this. Suppose there are two businesses with $1,250 in weekly revenues, $5,000 in weekly expenses, and $100,000 in cash, with the one difference being their current growth: one is growing at 3% per week, while the other is at 3.5%. If you run the numbers, you'd find that the first startup would need $109,000 in cash to reach profitability, making it default dead, while the second startup would only need $94,000 in cash, suggesting that it could survive without needing to raise additional capital. Startups that currently default dead currently have one of two options: raising more money to extend the runway or becoming default alive. Assuming that funding conditions will get worse, startups may need to opt for the latter rather than relying on the former. This would include lowering customer acquisition costs by slashing marketing spending, conducting layoffs, focusing on core markets, and ensuring profitable unit economics.

Not All Doom and Gloom

While the current startup ecosystem is showing signs of slowdown and decline in some areas, it is important to understand that all of the metrics being measured are relative. The funding cycle between 2020-2021 was extraordinary, as Venture Firms, Private Equity Firms, and Crossover funds rushed in to close deals and deploy capital. US Venture funds raised a record $128.3 billion in 2021, which itself was up 50% from the previous record set in 2020. What's even more breathtaking is the total capital deployed by Venture firms, which shattered all previous records, crossing the $300 billion mark for the first time. Investors deployed $329.9 billion in 2021, which nearly doubled the previous record of $166.1 billion set in 2020.

All of this suggests that the capital raised and deployed in the previous two years was an exception rather than the norm. Contrary to popular opinion, Venture activity hasn't plummeted but rather seen a slowdown compared to the extraordinary circumstances of the past. Venture firms have already raised $137.5 billion from investors through the first half of 2022, which is just shy of 2021's full-year total. Furthermore, US Venture Capital Dry Powder - The amount of money raised but not deployed rose by $100 billion to a record $539 billion in the first half of 2022. This indicates that there is plenty of liquidity still prevailing in the system, which can eventually be deployed when conditions improve over the next year or so.

One note to consider here is that the current down cycle could be beneficial in helping startup founders trim the fat in the company and correct the missteps seen during the pandemic. For one, the funding boom has led to intense competition in hiring and retaining the best talent. This has meant that founders have had to give an arm and leg away while negotiating, severely diluting the stake of everyone involved early in the startup's lifecycle. Even when founders have managed to land the talent they have been looking at, reports of employees taking advantage of remote work (like holding two jobs or working for only a few hours a day) have become a common issue. As the economy deteriorates further and more employees join the workforce, founders can take time to evaluate and reward the most productive employees while letting go of those who have taken advantage of the system previously. Companies like Airbnb, Amazon, and Paypal went through drastic changes during the previous venture downturns and focused on strengthening their fundamentals, eventually being rewarded by their customers and the financial markets. A similar fate could await the next set of startups to take action in the current cycle.

Bottom Line

The startup ecosystem has seen a drastic change over the past year, as the size and number of investments made have declined substantially compared to the boom in 2020 and 2021. Macroeconomic Uncertainty coupled with structural issues in the industry, like high valuations and founders unwilling to compromise on terms, could risk extending the length of the current Startup Winter. While things certainly look bad for founders, it is important to look at history and understand that startups have spent the period reworking and strengthening their fundamentals to create value rather than relying on investments. In many ways, the current Startup Winter will be a make-or-break affair for founders, which will determine who can go back to the basics to achieve unit economics and profitability to survive the challenging conditions and who will ultimately perish. Time will tell how founders adapt and respond to the conditions and come out of the current downturn.