A new world view for VC’s: Why startup funding has changed forever.
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Written by Hasan Surtiwala
For more than a decade, startups have had excessive access to risk capital, fuelled by record-breaking Venture Capital funds, creating a myriad of a companies, and new-age entrepreneurs. Some credible, others questionable, but all had one thing in common. They were built on unsustainable metrics, focusing largely on capturing the market and customer base rather than creating end-to-end value, i.e., for both their customers and investors. Today, many wonder how investors will ever see a return on investment, that too in this lifetime, and whether most of the startups will be just another part of the greatest bull-run’s history, and why investors should look at startup funding differently than previously.
The resting bull
The last bull run which ran from roughly 2009-2019 (and a year more into post-covid depending on how one would view a bull-run) totalling 127 months, is accounted for the greatest of the 3 biggest bull-runs in history, compared to the 113 months bull-run from the beginning of the 1990’s and the post WW2 bull-run. The market saw an influx of millennial investors, financial anarchists and young entrepreneurs looking for answers to the problems created by generations before them. While many might argue that some tech giants have created a new generation of societal problems, the world economy cultured a financial frenzy post 08’ crisis, inflating markets to unprecedented heights.
Low inflation, historical low interest rates, globalization, and access to information and high-speed network connectivity paved the way for young to senior investors and traders with cash from historic amounts of money printed by the Feds, hyping an IPO market for just about any startup investor to opt for their exits. Netflix and Meta (formerly Facebook) rose 9,900% and 740% respectively from date of IPO till 2021 (market crash arguably began mid 2022), created a FOMO (fear of missing out) amongst investment funds, who had no choice other than deploying capital into startups, which might’ve resulted in a shoot and aim type of due diligence. Fast forward to 2022 and 2023, the bulls has come to rest, and the companies who secured funding based on moulding their pitch according to VC’s internal models, metrics, and existing portfolio, are now “left with the bill”.
According to PitchBook data, VC investments reached significant heights during this period. In 2009, global venture capital investments amounted to around $37billion, and by 2021, that number had surged to over $300 billion. These investments fuelled the growth of innovative companies, with the number of ventures backed unicorns (+$1billion valuations) increasing dramatically. In 2009, there were only 14 unicorns, while by 2021, that number had risen to over 800.
The old order of funding
Having personally looked at hundreds of pitchdecks throughout my time, one common-trait was to showcase how investors can gain liquidity for exiting their investments, by investing in a highly illiquid venture. While that’s the general nature of capital, it became almost a “puff, puff pass” type of funding process, where the pre-ipo investors were left with the last “bid of the bud”. A pre-seed funding would typically invest with smaller ticket sizes, based on a carefully planned funding roadmap, so an investor could “clearly” see how the value would inflate based on the next VC determining their market value. Like an unlisted stock, the company would be valued not determined by the market, but how much money has been burned in order to capture as much market share, measured by users/customers as possible. The old-age saying “it takes money, to make money”, a hyper growth model, vastly unsustainable, with most companies not making any money was apparent with startup funding. Startups were initially funded with real money, but inflated with artificial value, and while many of today’s tech giants created value for the market and its users, its questionable how many of those companies will exist in the future, due to being less of a cash cow and more of a cash-burn however large those numbers might be.
A paradigm shift.
With so much funding competition from fellow startups colleagues, startups who didn’t fit the mould, have resorted to either bootstrapping (going as far as possible with little to no funding), taking in venture loans (the types of loans which made Silicon Valley, Silicon Valley), or the nature of crowdfunding, which changed and democratized startup funding forever. Small time investors are now able to invest on par with the coveted circles of venture capitalist. The market determining the value of a company, just like the listed public markets. According to data from Statista, global crowdfunding volumes soared from $530million in 2009 to over $17billion in 2020.
Combined with the rise of democratization of angel investing, incubators/accelerators, more government funding, and innovative loan-financing from providers such as the now defunct Silicon Valley Bank, financial innovation with the power of blockchain technology, such as tokenization, where investors can buy ”derivative like” shares of a company and directly invest in a digital assets which corresponds 1:1 with the ownership of the company, VC’s are left with 3 choices:
- Join the unlisted public market with the “common investor”.
- Deeper due diligence processes resulting in fewer value investments, with capital reserves for follow-up investments, rather than multiple “flavour of the day” bets or…
- Fuel the current portfolio hoping that they’ll turn a profit overnight and not cease to exist any time soon.
Giants like Google, Meta, Amazon and Microsoft, and Apple built world changing platforms, serving the market first and as a biproduct, served the investors as well.
Arguably, there will be fewer of such giants, as most capital is placed and hoarded by aforementioned robust companies rather than in the hands of hyper growth ventures waiting to be acquired by the giants. With that being said, investors can truly benefit from not focusing on exit scenarios, as this nature structures ventures around unsustainable metrics, just to pass “the bud” on to the next, but rather how the company will grow on a solid foundation.
Horizon 20/20
Looking back at how the latest bull-run corrupted, shaped, disrupted, and paved startup funding it’s time for venture capitalists and private investors to look ahead, and reimagine how companies, markets and founders are valued. As there are many reasons a company can succeed there are only a few reasons a startup can fail. Historically a startup fails due to weak product-market-fit, lack of funding, poor timing, troublesome founder dynamics, too much equity sold in smaller rounds and not making any money. As mentioned, and seen time over for the past bull-run, startups have been funded based on hyper-growth metrics, where the cost of capital was equal to their next funding size.
This has left a massive basket of companies, with hundreds of millions (and in some instances billions) of any fiat currency denomination you can think of, in year-on-year losses, only to spend more resources looking for more funding to keep the ship from not sinking. Now time has come, for investors to look beyond and become selective and critical of their portfolio companies. To focus on sustainable growth models and capital preservation rather than capital destruction.
Consequently, investors focus should shift away from company valuation. Sure, equity plays a role IF the startup is catering to the investors alone and not the market itself, with either a future exit or the next funding round from their scenario-based investment roadmap in sight. But startup funding is illiquid, stagebased pricing only to “off-load” the destiny of the company to the next highest bidder and going back with more cash in hand for the next “cycle” of same nature.
Taking responsibility
The availability of abundant capital led to irresponsible spending and mismanagement from startup founders. Fuelled by VC funding, companies sometimes prioritized rapid growth at the expense of profitability. Excessive spending on customer acquisition, marketing campaigns, and aggressive expansion has resulted in unsustainable business models. Notable examples are WeWork and Uber, which reported substantial losses year after year despite its significant market presence.
Founders themselves are guilty in being blinded by illusory valuations, and kept it as a metric of success rather than focusing on profitability, value to their clients, customers, market and equally important their investors. The nature of capital is to shift cash distribution in the market to the hands of those who create the most value, only then there will be a sustainable economy and growth of startups, rather than fake value created from real money.
The backers of Wework have lost almost 90% from its peak value, while the real cash to loss ratio was $10billion from SoftBank’s investment. As this is just one of many such examples, founders and investors alike such ask themselves, who in the end are to be blamed?
– Hasan Surtiwala
Hasan Surtiwala is one the co-founders and CBO at Penning Group, a company group providing direct access to from TradFi to DeFi related to payments, broker services and through Penning A/S investing in the digital assets space.
