How startups are dealing with the hardest fundraising climate in more than a decade

When Cube CEO Christina Ross kicked off fundraising efforts for her financial planning software startup in February, cloud stocks were already down 40% from their 2021 highs. They had a lot further to drop over the next few months.

By the time Cube announced its $30 million Series B deal in mid-June, the broader market was about to close out its worst first half in 50 years, led by a collapse in high-growth tech stocks, which had been the top outperformers in the Nasdaq Composite's ascent to a record in November.

The private financing market tends to lag public stocks, giving venture investors time to adjust their expectations for potential exit prices. But the shift is now in full effect. The shutdown of the IPO market has resulted in a virtual freeze in pre-IPO rounds, and the dramatic contraction of software multiples has stalled private deal flows. Companies are doing whatever they can to avoid the dreaded down round — a funding that values them at less than their previous round.

Ross, who founded Cube in 2018, knew that any valuation in today's world would be well shy of the frothy days of 2020 and 2021. But she was also aware that many of those high-priced deals created an albatross for the recipients, who now face a new and gloomy reality.

"There was a reset that happened," said Ross, who declined to disclose additional terms of her deal, including valuation. "We were just fortunate not to have gotten caught up in what happened the year before."

The number of financings of startups valued at $1 billion or more almost tripled last year to more than 600, with the amount invested in those deals climbing to $140.8 billion from $52.7 billion in 2020, according to the National Venture Capital Association. As Ross points out, some companies with $10 million in annual sales were obtaining billion-dollar valuations, giving them revenue multiples of 100.

Those days are over. The Fed's aggressive interest rate hikes designed to tamp down surging inflation, which hit a 40-year high, sent investors fleeing from the riskiest companies. They particularly dumped companies that would need to continue tapping the capital markets to fund operations.

Swedish fintech company Klarna, valued last year at $46 billion, is now looking to raise money at a $6.5 billion valuation, The Wall Street Journal reported last week. That follows a roughly 90% plunge in the share price of U.S. rival Affirm from its peak in November. A Klarna spokesperson declined to comment.

Instacart lowered its own valuation by almost 40% in March, announcing to new recruits that they could get stock at a reduced price by joining. In the secondary markets, where employees and ex-employees from private companies sell a portion of their equity to get some liquidity, deals are "getting done at more favorable terms for investors," said EquityBee CEO Oren Barzilai.

EquityBee connects startup workers with outside investors who are willing to write checks so people can exercise their options, generally after leaving a company. In return, the investors demand the right to a certain amount of the equity in the case of an initial public offering or acquisition. Barzilai said that investors are now often getting 30% to 40% of the potential upside, compared with 5% to 10% a year ago.

"The trends have shifted," Barzilai said. "Companies that were super hot last year are not as favorable as they used to be."

Late-stage companies that are raising money generally have to either take Klarna's path and accept a lower valuation or give highly preferential treatment to new investors, allowing them to get their money back before anyone else or make a higher return in an eventual exit event.

Startups more often tend to take the latter route, accepting what's known on Wall Street as "structure" into their financing deals. Larry Aschebrook, managing partner at growth stage venture firm G Squared, said his team isn't putting money into any deal without "downside protection."

"You might get a top-line number that is either flat or up depending on the underlying business, but there are some embedded protections," said Aschebrook, adding that his firm's level of cash deployment is down about 60% from a year ago. "In the last few years, very few businesses had any structure in equity rounds given how accessible the capital markets were."

Cube is at an earlier stage and isn't as directly effected by the whims of the stock market. Still, Ross faced questions this year that she didn't as recently as early 2021, when her company raised its $10 million Series A. For example, investors are asking if the company will have enough cash to last 36 months, whereas previous demands were for the money to last 18 to 24 months, Ross said. Also, profitability is important even for young companies with fast growth.

"The diligence was a lot deeper, particularly on metrics that never would've come up before like margins," Ross said. Investors also asked about sales efficiency and net dollar retention, or how much existing customers are keeping and adding to their purchases. "These weren't even questions that were asked last time around," she said.

Christina Cacioppo, CEO of compliance and security software startup Vanta, raised money in 2021 and took on another round in May in what she called "a very different fundraising environment."

Last year, revenue growth was the favorite subject among venture capitalists assessing Vanta. In 2022, Cacioppo said, it was the burn multiple, a measurement described in a blog post by David Sacks of Craft Ventures, one of Vanta's backers. The number represents the amount of money a company spends in order to generate a dollar of new recurring revenue. 

"If you're not growing efficiently, there are not many people who want to fund that in this market," Cacioppo said. Her company was valued at $1.6 billion in the latest round.

Investors are now routinely asking for a company's so-called "magic number." That calculation factors in the growth of revenue over time relative to sales and marketing expenditures, and tells prospective investors how long it will take for a company to recoup every dollar it spends in those areas.

Raj Verma, CEO of database startup SingleStore, said such calculations were a hot topic with investors as his company was pursuing its latest round of funding, which will be announced later this month. SingleStore raised an $80 million round in September.

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

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

It's "the one metric that people are bringing thousand watt bulbs to," Verma said.

The bottom line for investors is they want to have confidence that the money they're putting in can last a while, because the era of cheap and readily available cash is over. And they want to enter at a price that reflects the public market shakeout.

Mike Volpi of Index Ventures said that while deal activity has slowed across the board, there is much more action in the earlier stages than in the growth equity market, where there's "very little liquidity."

Volpi said that there are no longer Series A rounds valuing companies at $200 million, but they're still historically high, in the $50 million to $100 million range, which is back to about 2018 levels.

Due diligence is also back.

"The timeframe on which deals get done is a little longer now, which is healthy for both companies and VC firms," Volpi said. "It gives us more opportunity to evaluate an idea, talk to people and do reference checks. For the company, it helps them figure out which VC they actually like."

As for Index's advice to its portfolio companies, Volpi said companies should adjust based on what they're seeing from their customers. But if clients are continuing to spend and the business has money to last a couple years, don't change just because the market has contracted.

"We're encouraging people to keep doing what they're doing, because the world will be in a different place in two years," he said. "If you're seeing signs of customers changing then adjust. But if not, and you have capital, don't get freaked out. While everyone else is getting freaked out, this is the opportunity to take share."

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