Earlier this week, I came across a curious quote while reading Sammy Abdullah’s notes on the book eBoys by Randall Stross, chronicling the founding and early days of Benchmark. In it, the quote read: “What’s it like recruiting when the stock price is so high? Really hard. The options offered to new employees were certain to be valueless, as they would depend on the stock ascending still higher. I mean, it’s at such a ridiculous level, there’s going to be a big fall here. The question is sort of when and how.”
2022’s VC landscape
After an insane 1.5-year run, I’ve seen valuation multiples that were 100-200x a company’s revenue get funded. At the end of the day, venture capital is belief capital. And it is not my place to criticize someone else’s belief, but I know that same belief will falter in the coming months to year. We’ve already seen public market stocks fall and VC exit values plummet 90% in Q1 this year. Tiger Global fell 7% in 2021 – its first annual loss since 2016. $10,000 invested in the basket of IPOs for 2021 would be worth $5,500 today. We’re in a correction soon. Or as Martin who I’ve had the pleasure to meet via On Deck calls it, the “Great Asset Repricing.” When exactly? I don’t know.
That said, as a function of the great repricing, VCs are coming in with more aggressive terms to hedge their bets. Greater liquidation preferences. More aggressive anti-dilution provisions. For LPs into late-stage capital allocators, they’re expecting greater minimum hurdle rates. In other words, they expect investors to have an internal rate of return (IRR) of at least 20%. Every year, an investor’s assets need to be worth 20% more than the year before. This is up from 10-12% from back in 2021, which I cited in last week’s blogpost.
And as Martin surmises, we’ll see a lot more inside rounds (investors re-upping in their own portfolio) for two reasons:
- Insiders have more information.
- Insiders tend to be more conservative on valuation.
And “companies without significant traction to face a very tough fundraising environment in the near term.”
What the hell does all this esoteric jargon mean for employees?
The best private companies are still playing ball with the ball on their side of the court. They have leverage. But most companies that were funded in the past one and a half years won’t. As such, there are four things that will and have already started to happen:
- You don’t raise. Cut your burn rate. Stay close to the money. Extend your runway, but set clear expectations. That’s what Alinea did at the start of the pandemic. Your team is in it for the long run. Many may choose to leave, but that is the reality.
- You raise, but on a flat or down round. This is better for your employees that you plan to hire, since there is a better chance that their shares will appreciate in the next funding window. But you’re not getting any fancy press releases.
- You raise on an up round. That’s great. You make the headlines on TC or Forbes. But it increases the pressure for both your current team members and new hires. VCs add in more aggressive terms. No one’s getting paid until investors get 2-3x their money back via a liquidity event or exit. As a founder, you have more pressure to shoot for a bigger exit than you would have needed to shoot for otherwise. Or else, the team that bled for you for years will get little to no upside for their time and effort.
- Or, you go out. Monetarily, no one wins.
So what can you do as a startup employee? Or as a prospective startup employee?
Just like I recommend folks to think like an LP to get a job in VC, to get a job at a startup, think like a VC. Or as Nikhil Basu Trivedi puts it, find employee-VC alignment.
Ask questions on revenue drivers. What do growth metrics look like for the last three months? How does churn and net retention look like? When do they plan to raise their next round? And simply, how much revenue is the company generating? Does the price-to-sales multiple make sense? For example, is the latest valuation of the company 200x the company’s revenue or 50x. The former is likely to come with more insane expectations from their investors. In December last year, Retool wrote a great piece why they chose to raise at a lower valuation and why that makes sense for their team members, which I highly recommend checking out.
Of course, as a startup employee, you want your shares to increase in value, but too much too quickly can be detrimental. We’ve seen the recent example with Fast. They were last valued at $580M according to Pitchbook, but were only making $600K in revenue, but was burning $10M a month. Almost a 1000x multiple!
A growth-stage startup grounded on fundamentals (i.e. traction) will likely still be able to raise. A startup funded on promises that has yet to deliver may not be able to. As Samir Kaji tweeted yesterday:
In closing
Contrary to popular opinion, a company’s valuation is not how much a startup is worth, but rather it is a bet on the chance they will be as big as their incumbent competitor. Take Yuga Labs as an example. They recently raised $450M on a $4B valuation from a16z and a number of other incredible investors. With that capital injection, they are building Otherside, their take on the metaverse integrating their various NFT properties. Epic Games, on the other hand, is valued at $31.5B. $32 billion for ease of calculation. Yuga’s $4B valuation is a bet their investors are taking that Yuga has a 12.5% chance (4/32) to be as big as Epic, and by transitive property, Fortnite.
As an employee, the bet you make is not with capital, but with time – the world’s scarcest resource. We’re coming into a world soon where cash is king. Make your judgments accordingly.
To close, I had to cite Brian Rumao‘s tweet, early investor in Fast. He boiled it down beautifully in 280 characters.
Photo by Yiran Ding on Unsplash
Disclaimer: None of this is investment advice. This content is for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Please consult your own adviser before making any investments.
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