Startups betting on the end of cheap capital face tough decisions

Cube CEO Christina Ross (center) with her team


When cube CEO Christina Ross began raising funds for her financial planning software startup in February, with cloud shares already down 40% from 2021 highs. They still had a lot to lose over the next few months.

By the time Cube announced his $30 million Series B deal in mid-June, the broader market was about to close its Worst first half in 50 yearswhich led to a collapse in fast-growing technology stocks, which led the gains in the Nasdaq Composite’s ascent to a record in November.

The private equity market has typically underperformed public equity, giving VCs time to adjust their expectations of potential exit prices. But the shift is now in full swing. The closure of the IPO market led to a virtual freeze in pre-IPO rounds, and a sharp reduction in software multiples stalled private deal flows. Companies are doing everything they can to avoid the dreaded round down—funding that values ​​them less than their previous round.

Ross, who founded Cube in 2018, knew that any valuation in today’s world would be far short of the frothy days of 2020 and 2021. But she also realized that many of these costly deals created an albatross for the recipients, who now face a new and grim reality.

“There’s been a reset,” said Ross, who declined to reveal additional terms of her deal., including appraisal. “We were just lucky that we didn’t fall into the trap of what happened a year earlier.”

According to National Venture Capital Association. As Ross points out, some companies with $10 million in annual sales were valued in the billions of dollars, giving them revenue in multiples of 100.

Those days are over. Fed aggressive interest rate hike designed to contain rising inflation, which has reached a 40-year high, forced investors to flee from the riskiest companies. In particular, they dumped companies that needed to continue to use the capital markets to fund operations.

Swedish fintech company Klarna, valued at $46 billion last year, is now seeking funding to raise funds valued at $6.5 billion. It is reported by The Wall Street Journal. last week. This follows a roughly 90 percent drop in the value of the American competitor’s stock. Confirm from its peak in November. A spokesman for Klarna declined to comment.

Confirmation of the fall from the November high


Instagram lowered his own rating by almost 40% in March, announcing to recruits that they can get shares at a reduced price by joining. In secondary markets, where employees and ex-employees of private companies sell some of their capital to get some liquidity, deals “are made at better terms for investors,” he said. EquityBee CEO Oren Barzilai.

EquityBee connects startups with outside investors who are willing to write checks so people can realize their potential, usually after leaving the company. In return, investors demand the right to a certain share of the capital in the event of an initial public offering or acquisition. Barzilai said that investors now often get 30% to 40% potential upside compared to 5% to 10% a year ago.

“Trends have changed,” Barzilai said. “Companies that were very popular last year are no longer as favorable as they used to be.”

Late-stage companies that raise money usually have to either go the Klarna route and settle for a lower valuation, or give new investors very favorable terms, allowing them to get their money back early or make higher profits in the event of a possible exit.

Bottom protection

Startups are more likely to choose the latter path, adopting what Wall Street calls “structure” in their financial transactions. Larry Ashebrook, Managing Partner, Growth Venture Company G squaredsaid his team does not invest in any trade without “loss protection”.

“You can get an initial figure that either doesn’t change or increases depending on the core business, but there are some built-in safeguards,” Ashebrook said, adding that his firm’s cash usage rate has dropped by about 60% compared to last year. “Over the past few years, very few businesses have had any structure in equity rounds given how accessible the capital markets have been.”

Cube is at an earlier stage and not as directly affected by the vagaries of the stock market. However, this year Ross has faced questions she didn’t ask as recently as early 2021 when her company raised its $10 million. Serie A. For example, investors are asking if a company has enough cash to last 36 months, whereas previously it was required to have enough cash to last 18 to 24 months, Ross said. In addition, profitability is important even for young companies with rapid growth.

“The diligence was much deeper, especially around metrics that would never have come up before, like margins,” Ross said. Investors also asked about sales performance and net dollar retention, or how much existing customers are saving and adding to their purchases. “These were not even the same questions that were asked last time,” she said.

Cristina Cacioppo, CEO of Compliance and Security Software Startup Guyraised Money in 2021 and took over one more round in May in what she called a “completely different fundraising environment”.

Vanta CEO Cristina Cacioppo


Last year, revenue growth was a favorite topic among venture capitalists evaluating Vanta. In 2022, according to Cacioppo, it was a multiple burn, a measurement described in Blog post David Sacks of Craft Ventures, one of Vanta’s sponsors. The number represents the amount of money the company spends to generate a dollar of new regular income.

“If you don’t grow efficiently, there aren’t many people in this market who are willing to fund it,” Cacioppo said. Her company was valued at $1.6 billion in the latest round.

Due diligence returns

Investors now regularly request the so-called “magic number” of the company. What calculation take into account revenue growth over time compared to sales and marketing expenses and tell potential investors how long it will take for a company to recoup every dollar spent in these areas.

Raj Verma, CEO of a database startup One stop shop, said the settlement was a hot topic for investors as his company was pursuing the latest round of funding to be announced later this month. In September, Vanta raised an $80 million round.

Verma said that this time around, investors wanted to know how long it takes for a sales rep to become productive, the ratio of account managers to sales engineers, and the number of salespeople who contributed to the annual recurring revenue goal.

He said it takes 14 times more money to generate revenue from a new customer than from an existing customer, making net dollar retention an increasingly important metric.

That’s “the only number that people rate a thousand-watt light bulbs,” Verma said.

The bottom line is that investors want to be sure that the money they invest will last for a while, because the era of cheap and easily accessible cash is over. And they want to enter at a price that reflects the shock of the public market.

Mike Volpi of Index Ventures said that while transaction activity across the board has declined, there is far more action going on in the early stages than in a rising stock market where there is “very little liquidity.”

Volpi said there are no more Series A rounds valuing companies at $200 million, but they are still historically high, ranging from $50 million to $100 million, roughly in line with 2018 levels.

Due diligence also returns.

“The time frame in which deals are made is now slightly longer, which is beneficial for both companies and venture capital firms,” Volpi said. “This gives us more opportunities to evaluate the idea, talk to people and check recommendations. For the company, it helps to understand what kind of venture capital they really like.”

As for Index’s advice to companies in its portfolio, Volpi said companies should adjust based on what they see from their customers. But if customers keep spending money and the business has money for a couple of years, don’t change just because the market has shrunk.

“We encourage people to keep doing what they are doing because in two years the world will be in a different place,” he said. “If you see signs that customers are changing, adjust. But if not, and you have the capital, don’t be alarmed. While everyone else is scared, this is an opportunity to share.”

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