This article appeared in Fintechly on July 26, 2022.
Recent market volatility should encourage founders to shift away from optimising short-term valuations and toward mitigating long-term financing riskOver the past several months, we’ve seen valuations of public tech companies plummet, fintech companies included. Many fintech companies that went public in 2021 are down 70% to 80% from their highs, and some are down more.
With 9.1% inflation, a war in Ukraine, supply chain bottlenecks, and energy shortages, it’s an unsettling time to say the least. But at Cota Capital, we think the current resetting of valuations – both public and private – can be a healthy development.
For fintech investors and entrepreneurs, it presents a welcome opportunity. Investors with dry powder can patiently support emerging companies, knowing that the rewards will come for businesses that create and capture value. Entrepreneurs who have the acumen, resilience, business model, and, critically, vision, to achieve long-term success will do so in an environment with less competition, less frothy growth, and a better ability to attract talent – all with a longer runway to truly achieve a product/market fit.
Valuation volatility should encourage founders – especially younger entrepreneurs who may be experiencing their first macroeconomic downturn – to shift their thinking away from optimising short-term valuations and toward mitigating long-term financing risk.
So what does this mean for entrepreneurs who are raising money now? In our view, even with a reset in valuations, high-growth technology companies aren’t going anywhere. In fact, companies driven by enterprise technology, within fintech specifically, will continue to prosper if they can make it through to the other side of the current instability. How do promising venture-backed startups and their leadership teams protect their competitive position and, to the extent possible, their long-term valuation prospects?
Don’t try to keep up with the Joneses
The world has changed, so these startups shouldn’t benchmark themselves against what their peers may have raised in the previous environment.
Even if Startup X reached unicorn status last year, it might not be able to hang on to that billion-dollar valuation the next time it goes for funding. In fact, optimising around a post-money, post-mega-round valuation generally leaves founders and operators with little room to manoeuvre in response to future changes to the macroeconomy, like high inflation, economic slowdown, or all-out recession. Raising a follow-on round in that environment may prove far more difficult, if not impossible.
For example, sometimes more than one investor follows this strategy in a single segment, potentially leading to overfunding, poor capital allocation decisions, and a growth-at-any-cost strategy that fails to take root. Often the underlying market will take much longer to develop, and the portfolio company will likely spend funding far in advance of real market readiness.
Focus more energy on picking the right venture partners
Partnering with committed investors who will be there for the long term and can add value to your business is much more important than optimising for valuation. What startups really need, more than astronomical valuations, are seasoned investors who will roll up their sleeves, get to work on startups’ behalf, and provide the kind of insight and advice needed to build category-leading companies.
Often the strength and long-term view that comes with syndicate financing are precisely what’s needed, even at lower valuations, when economic headwinds are strong. Given the likelihood of recession, what are the founders’ plans to finance the company for the next 24 months? Building quality syndicates that can offer much-needed reserve financing – ideally 1:1 even at the B round – is a natural hedge against the type of macroeconomic downturn we are currently experiencing.
Be efficient with capital
Management teams will spend money on less critical things when they have US$50mn in the bank vs $5mn. In other words, they don’t think as hard about being efficient when they don’t feel they need to be efficient.
But endless equity capital can be an expensive way to build a company – and maybe not the best way. In the end, companies will eventually need to grow into the post-money valuation of their mega-round, and it’s actually very hard for most companies to accelerate their market growth without some material breakthrough in their product that impacts the total addressable market. We believe that entrepreneurs and companies seeking to deliver efficient, if less frothy, growth will forge a likelier path to success.
Turmoil in the public markets is stomach-churning for everyone. But turbulence is not a cause for panic. Focusing on the business of your business, making capital-efficient decisions, and securing a solid long-term financing strategy are tried-and-true options for founders looking to ride out challenging times.
Yes, valuations of private companies may go lower and plans to go public could be shelved in the near term. But we believe what is happening now will ultimately prove to be a positive development, ushering in a period of rational valuations and an environment highly conducive to healthy, long-term returns.
About the Authors: Kevin Jacques and Ben Malka are Partners at Cota Capital.