There’s been a healthy amount of chatter lately from analysts and tech writers that we are approaching a meltdown in startup financing. Unicorns, those startups valued at $1 billion or higher, are being downgraded at a rapid clip. The most recent victim is Flipkart, an Indian e-commerce firm devalued last month from $15.2 billion to $11 billion. Another unicorn, UK-based Powa Technologies, was once valued at $2.7 billion but went bankrupt in February. Several other well-known unicorns that have experienced valuation cuts in recent months include Palantir, Dropbox, Snapchat, Jawbone, and Zenefits. This is disastrous not only for the companies but also for the limited partners of the VC firms who are seeing their investments devalued by 30% or more overnight.
But what’s going on in the market right now is not a bubble about to burst as many have suggested; it’s a logical multiples compression. Major tech companies, including Workday, LinkedIn, and Twitter have all lost considerable market share in the past year, igniting investor fears. While the stock market is subject to global and national events — predominantly the oil crisis, Syria, and China’s recession — VCs are taking note. The smart ones are looking at everything they hold more closely and lowering the multiples they use for valuation to lower the risk.
This is not cause for fear and gloom. To the contrary, this correction is a healthy turn of events for the SaaS marketplace. When SaaS began to pick up steam about 10 years ago, there was heady excitement around building great companies that would change the software industry for the better. SaaS was a revolution: It was going to deliver customers much faster ROI and measurable business benefits. Lately, it seems startups have lost sight of those lofty goals. Many founders are focused too much on chasing money and getting to the next funding round; VCs have been going along with this game wholeheartedly. Currently, there are 153 unicorns at a combined valuation of $535 billion, according to CB Insights.
In a recent meeting I had with a VC firm on Sand Hill Road, one of the partners shared with me an all-too-common story about a meeting he had with a startup. The company had modest revenues (in the mid-six-figures) yet was clearly seeking to be the next unicorn with a billion-dollar valuation. The VC turned them down, offering a $600 million valuation instead. The startup founders walked. Really?
In this market, startups should be expecting more realistic multiples, not the 40X (and higher) that some companies have previously been awarded. Just as IPOs are on a downward trend, it’s reasonable to predict that there will be many more unicorn failings and far fewer new unicorns born in the coming months. Something’s got to give.
First and foremost, startups should focus more of their efforts on building value and less on fundraising. Over the last few years, valuations have become disconnected from the business. It’s almost as if founders are running two different organizations: the business that is developing products and services and (hopefully) serving customers, and the business that is focused on constantly raising money. That strategy backfires when a company doesn’t grow revenues and customers as fast as predicted by those huge multiples, causing the devaluations and down rounds. The ultimate disaster is when the company’s churn and burn fundraising cycle stops short once investors finally see the light and go away. Before long, the company’s just another page in startup history.
There’s an answer to all this. Get back to the basics, beginning with sensible metrics. Value unit economics (with the customer as the unit) and funnel metrics. Know your conversion rates, average sale prices, churn rates, cost to acquire, and other core customer economics. These numbers will help you accurately predict revenues and a customer’s lifetime value. Eyeballs on a website are a shallow measure of startup financials. Too many young companies are asking for money based on irrelevant metrics. The founders who are good at fundraising but bad at building a healthy business are in an unpopular spotlight right now.
It’s not over for SaaS
The good news is, the VC funding well hasn’t dried up for financially sound, well-run companies. Further, well-funded and sound companies will gain an advantage. They have fewer competitors and face less of a threat that a fresh unicorn will make a big wave in their market. As fundraising gets tougher and as companies begin focusing more on their unit economics and building a healthy business, the SaaS sector will benefit. I’d prefer to not think of SaaS as a bursting bubble but as an overgrown rose bush that needs some pruning in order to stage it for the next phase of growth. Through more sound business practices, the SaaS industry can shore up what has been accomplished already. There will be some failing startups because of it, but revenue will migrate to the healthier companies.
A fresh start
Now’s the time for startups to delve into their financial analyses with fact-based measures and establish a valuation that holds water. When you raise money, don’t burn through the cash expecting another round to occur. Instead, be smart with your money, spending it acquiring customers at a rate that makes sense with your customers’ lifetime value (LTV). This entails knowing your Cost to Acquire a Customer (CAC), because if you spend too much on acquisition costs as a percentage of LTV, you’re bound to run into trouble sooner rather than later.
Keep a close eye on your burn rate as you consider expanding staff or benefits. Finally, reconsider those dreams of the IPO. Going public is viable if your primary goal is to achieve an exit and move on or if you need to raise a large round for R&D. Otherwise, consider the many (and there are many) benefits of staying private. There’s far less pressure on startup execs when the valuation is modest and fundraising is not core to survival. You can spend your time doing what entrepreneurs love: finding a market niche, generating new ideas, improving products, and building a culture where people love coming to work every day because it’s meaningful and fun. By turning away from the monopoly money and back toward helping customers succeed, life in a startup can be more stable and vastly more rewarding.