FAQ for Startups Navigating the Downturn
By Yin Wu, Co-Founder & CEO
Understanding the nuances of equity is more important than ever. We've compiled answers to the most common questions from recent conversations with over 100 startups.
1. What is causing the bear market? How does this affect valuations?
While no one knows what will happen or how bad things will get, here is what we do know:
- Inflation is high, the Fed is raising rates, a recession looms, and public tech stocks are down 30-80%. This is different from the first decade of crypto’s existence.
- Lower public market valuations impact early-stage startup valuations: Late-stage VCs will price companies based on the IPO price targets in the near term. As public market valuations have collapsed, late-stage VCs have adjusted their valuations down. Early-stage VCs then need to offer valuations that can receive follow-on rounds.
- Fundraising is already much slower and valuations much lower: Late-stage valuations have crashed, and early-stage valuations have started to adjust. Some VC firms have paused on new investments, and many are investing very slowly. We have seen terms sheets and job offers rescinded.
- The VC ecosystem will take some time (years?) to be as hot as it was. Given the macroeconomic downturn, the LPs who give VC firms money are also cash crunched. This means many VC firms will struggle to raise their next funds, which may result in less capital flowing into early-stage companies in 2023 and 2024. Based on what we are seeing, capital will flow less quickly for the next year, likely two.
The role of the founder is often to be a paranoid optimist. Prepare for the worst and believe in the upside to give your company the greatest chance of making it through any macro environment.
2. What is causing private tech company valuations to crash?
Thank you to Pulley board member Keith Rabois at Founders Fund for his response to this question.
"I’ve been warning of a market crash since October 2021. The situation we’re in now is very similar to the dotcom burst of 2000. For the past few years, we deluded ourselves into thinking things could only go up and to the right. Back in 2000, multiple successive interest rate hikes by the Fed led tech stocks to crash. The exact same thing is happening now. When interest rates are going up, tech stocks will go down. Basic econ 101 tells us that when you raise interest rates, it impacts the discount cash flow formula for valuing stocks, with an exponential impact on further out years. Because tech companies tend to have longer paths to profitability, many founders are seeing their present valuations disproportionately cut. With publicly traded tech stocks down 50-90%, it’s become impossible for private companies to escape their public market comps (e.g., any crypto company inevitably is compared to Coinbase, which is down 85% from its highs)." - Keith Rabois, Founders Fund
3. How long will this downturn last?
It is unclear how long this pullback will last. It may be a few months like 2020, 18 months like 2008, or a brutal three-year correction like 2001. Understand your financials, and plan for all scenarios.
4. When should I think about fundraising in a downturn?
In order to survive, you must maximize your runway. Get to at least 24 months of runway, and ideally 30 months. You will need to raise 6-9 months before you run out of capital; if you have only 18 months of runway, you will need to raise in Spring 2023, in a potentially unfavorable fundraising climate.
If you have +24 months of runway…
Once you have 24+ months of runway, you are in one of two camps:
- Pre product-market fit - Focus on getting to product-market fit. Nothing else matters. Expect that the next funding round will be harder. Multiples will decrease, and the promise of future growth will not be enough to raise.
- Post product-market fit - Focus on operational efficiency. Improve unit economics and net margins, uplevel your team, take market share from incumbents and competitors.
If you have 12 to 24 months of runway...
To extend your runway, you have three options:
- Cut burn - Cut burn immediately if you cannot fundraise to 24 months of runway. If you are pre-product market fit, anyone who does not contribute to finding product-market fit should not be on the team. Prioritize runway over growth. Hire slowly until you have clarity on market conditions. If you have to do layoffs, cut more deeply than you think you need, and only do it once.
- Increase revenue - If you do not have a revenue stream, find one. If you have revenue and can raise prices, do it. Find ways to pull forward revenue with multi-year contracts.
- Raise - Fundraise immediately if you have less than 12 months of runway or cannot get to 24+ months through other means. Revisit investors from prior rounds, consider existing investors, and reach out to strategic angels.
If you have <6 months of runway and need to raise now...
Act immediately to get to 12 months of runway. Act with a greater sense of urgency. You should expect rounds to take twice as long to close.
Do not wait or delay. Follow the leads of Coinbase, SuperHuman, Tesla, and others in adjusting your plans quickly.
5. How should companies and their employees prepare for potential share repricings and down rounds?
Companies raised at very high valuations in recent years, so we anticipate more repricings and down rounds as the market continues to correct. Instacart did a share repricing in April 2022, and Klarna’s valuation dropped 85% from $45.6b to $6.5b in June 2022.
For employees: If you believe in the long-term success of the company, and you primarily attribute the repricing to short-term macroeconomic conditions, there may be a silver lining. You may have a greater upside if the company gives you a supplemental grant. If so, plan ahead for additional cash outlays - both for exercising your supplemental grant and for a potentially higher tax bill later down the line. If you have already exercised, you may want to speak with a tax advisor about how best to navigate your situation.
For companies: If your company does a share repricing, this will affect both recruiting and employee morale. With recruiting, a proactive repricing can have a positive effect. Any new hires will now receive options at a lower strike price, which means that they have more equity upside in the company. For recent hires whose options are now less compelling, it’s standard to issue new grants to ensure fairness and to keep them motivated. Repricings are mostly happening at the late stage, and the nuances at every company are different. We recommend speaking to your legal and finance teams to figure out the best option for your company.
6. How does the downturn affect the early stage?
Here’s the good news. The earlier stage of the startup, the less the downturn should affect your team if you have sufficient runway.
First, early-stage companies have a longer time horizon to return capital. Late-stage companies are expected to scale and go public in an adverse public market. Late-stage companies with a high burn need to restructure their teams to stay afloat.
Second, returning a $100m investment is very different than returning a $1m investment. Each round of funding closes opportunities. Acqui-hires are still possible at the early stage.
Finally, worth is relative. Getting 10x growth for a company at $100k in revenue is getting to $1m. $900k in revenue is achievable in any macro climate.
7. Is there any good news about the downturn?
Everything gets easier for startups in a recession, except fundraising. Bear markets are an excellent opportunity to focus on:
- Leadership - Hard times make for great leaders. Get your team up to speed on the new business environment quickly. Act swiftly when there are hard decisions to be made, explain the decision, and own the outcomes.
- Mission alignment - Clearly define and align around your organization’s mission. Define what it means to deliver real value. Anyone who is not on board should leave.
- Operational discipline - If your team can become efficient enough to survive the winter, it will pay dividends (perhaps literally) when times are good again. Build systems to track your key metrics and build an organization/community to drive those metrics.
- Upleveling talent - It is not a coincidence that many great teams (Amazon, Google, Facebook, Uber, Airbnb) scaled during a macro bear market. The war for talent subsides temporarily, starting a company gets harder, and many of the best people are available. If you have product-market fit and capital, aggressively aggregate and uplevel talent.
8. What is the standard for dilution for the seed round? For the Series A?
The amount of dilution depends on your industry and capital needs. Previously, we saw 10-15% dilution at the Seed Stage and a further 15-30% at the Series A. A great outcome in the bull market was if founders owned 50% of the company after a Series A. The rules have changed. Depending on the traction your company is seeing, expect valuations to decrease and founder ownership to decrease proportionately.
We have an equity calculator on Pulley that can model dilution through your Series A.
9. How do you manage your psyche during a downturn?
Thank you to Avichal Garg at Electric Capital for his response to this question.
"The most important lesson is that you cannot act out of fear. Fear leads to poor decision-making because it leads to a focus on minimizing the chances of failure. You must focus on maximizing your chances of success. Founders also have a tendency to take everything about their projects personally. This often leads to founders making themselves sick from stress.
Do not make yourself sick from stress. Do not act out of fear. Manage your own psychology to become even more ambitious, bold, and determined." - Avichal Garg, Electric Capital
10. Where can I find additional resources on navigating a downturn?
- [Video] "Operating During a Downturn" (Craft Ventures)
- [Article] "A Framework for Navigating Down Markets" (a16z)
- [Presentation] "Crucible Moment" memo (Sequoia)
- [Video] "How to Operate in a Changing Startup Environment" (Elad Gil & David Sacks)