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The Magic of Runway

For those in a hurry, there is a tldr section at the end, no offense taken if you look at that!

I am 33. That means that during the last real downturn between 2007 to 2009 I was able to get some insight when I was stagiaire with the European Commission where a lot of counter measures were implemented. During the previous downturn, i.e., the burst of the internet bubble my biggest investments were in Panini Stickers for the European Football championship in 2000.
Long story short, my firsthand experience with longer lasting bear markets is limited.[1]

What do I do to still be a good partner for the Start-Ups that I work with? The same that every entrepreneur does — speak with people who have been through it before. That’s what I did over the past weeks. With this short article I want to share some of the feedback I got and share you my subsequent analyses of what could happen going forward and why I believe that Runway might become the core Northstar for the next 18 to 24 months.

First question I asked was what the drivers of previous downturns were to understand the fundamental character of what is happening today. Core answer I got was that the real driver in previous downturns were demand backdrops.

The build up to the bursting internet bubble
In 2000, valuations were high, i.e. investors heavily weighted potential over substance and as they started to critically review that approach combined with some movements at the stock market (where a lot of companies had IPO’d that might not have been completely really there yet), suddenly funding became scarce for high burning companies that suddenly didn’t demand from other companies what caused less demand, led to lay-offs leading to less demand, and so on. The picture is kind of clear even though highly simplified. In 2007 a bunch of at least questionable financial assets defaulted at a rate that brought smaller, mid-sized and large banks to the point of imminent failure, leading to massive lay-offs, difficulties for the “real economy” to finance itself, leading to lay-offs, leading to less demand, leading to lay-offs, and so on again.

Following the assumption that synthetic financial assets as well as too high valuations are driven by the financial market, I wanted to understand why we did see valuations surge in the same way again over the past years, if it can at least be stated that this has a share in the mix. The answer was straight: Competition.

Let’s talk about the bull market
Given the long-lasting bull market of growth, profitability and cash richness (supported also be minimal interest rates for financing), there is simply so much money in the market that the supply and demand curve for strong start-ups is shifting in favor of the group that looks for funding, which means that investors must pay higher prices. Nevertheless, that also means that more weight is put on potential again.

How far down are markets already and how much further could it go?
To place the current situation right and going back to the initial hypothesis that demand is a driving factor for crises my next question is: Are we already in a demand crisis? I guess the best answer I got was “I have no glass sphere to predict what’s happening, but I don’t think I need one to say that no matter where we are right now, we can very well get into a demand crisis over the next months.”

What is safe to say though is the following: During the financial crisis governments started employing quantitative easing (i.e., lowering interest rates) to push demand in the market. The current situation is different. With governments increasing interest rates to the contrary of previous downturns, consumer prices are surging (not going to go into inflation numbers — let’s just take it as given) and demand is already decreasing right now.[2]

Another data point and that is a bit of a differentiator to the previous downturns is that we are seeing severe Supply backdrops in the market. Starting with the unavailability of computer chips going all the way to wheat, there is also the risk that supply can become a root cause for an economic downturn.

Given the lack of a glass sphere everything following is a potential path, but I think it makes sense to look at the more conservative end of potential developments.

How can markets become dry with so much money in existing funds?

I often hear that people state “yes all true but the funds have been raised and must be invested”. That is true, we must invest money. So why and how did in previous situations financial markets drought?

Yes, money must be invested but looking at limited partnership agreements (the shareholder agreement of a venture fund), they must be invested in new companies over five years. That means in situations where there is serious question around the state of the market, fund managers have all flexibility to hold their horses for two years on new investments. Additionally, it is likely that — not unlike public market investors — also VCs will look after their portfolio companies first in these times and allocate higher reserves then before to support the most impacted but fundamentally sound investments they did ahead of the downturn.

The consequence of that behavior is a contrary move to the supply and demand function that we had before. The bargaining power of VCs is shifting, and valuations will go down.

Even though I have used simplified versions of the supply and demand function here, my background is not in economics, and I want to break things down to the day-to-day business life, so the question is what does the above mean for founders?

Valuations are often pegged to revenue or EBITDA multiples and along the stronger weight of potential over substance, these multiples have been very high — at times even triple digit — in the past years. To explain the real effect for start-ups in case of a decrease of valuations I want to employ an example.

Let’s say I have been growing 100% over the past two years and the revenue multiple I raised my recent round on was 20.

In the following, the possibility of a demand crisis materializes slowing down my growth to 75% maybe even for two years because things turn sour. Additionally, investors become more careful leading to valuation drops and a new valuation base line of 15x revenue.

The first effect is my company (of course just fictively) has lost 25% of its valuation (15x/20x = 50%).

The second effect is that with the slower economy it takes much longer for me to grow into the valuation and possibly even bring sufficient traction for round at a higher valuation. Following the new 75% growth rate it will take the company over a year only to catch up with the valuation that it raised on today. Formulas below as mathematical explanation:

Valuation = Revenue * Multiple * Growth Rate [3]

Financing Round today:

Valuation reset at the moment of the downturn:

Revenue required to catch-up with valuation after slower growth and lower multiple:

Time it takes to get to the valuation:

Implicit is that if multiples go down even further because of less appetite from investors or growth is even slower because demand deteriorates further, the time to purely catch-up with the previous valuation will be even longer.

I again would not want to make predictions as to where valuations will likely settle in the next 24 months, but I certainly do not expect them to go back to the Q4 2021 levels. Thus, a certain catch-up is likely required for companies that raised at very aggressive levels in the past 12 months.

In that regard, time matters and thus, runway feels like an incredibly important factor to make sure that equity stories are not impeded due to bad timing.

Does a more conservative spending slow down growth and what does that mean for future valuations?

I have discussed this with some of my colleagues in the market both in early and late stage and have gotten a better picture through the discussion. The equation above needs to be completed by a factor that is capital efficiency and that would have an increasing effect on the valuation if high and a decreasing effect if low. Rationale for that is that with less money available in the market, appetite for large rounds is also lower and thus, smaller rounds will happen, while expectation on growth is not necessarily lowering linearly with less funding available. Thus, identifying profitable and scalable sales channels becomes more important, while growth at all costs becomes less attractive for investors given the lower valuation outlook. A colleague from a growth fund even mentioned that they were even trying to make sure that the companies at least have the chance to turn profitable with the initial funding to stay in full control.

Too long didn’t read

My three core messages and something that I always see when being asked are:

1. We do not have a glass sphere to know what’s happening in the next months, but for sure, uncertainty will never be higher than today with more information obtained day by day. Likely after the summer break things will become clearer. Preparing for the more negative scenario however puts companies in a better spot and here is why.

2. Applying some prudency in spending to have a good runway gives a company all chances to react to macroeconomic changes. If things get well soon, go back to spending, raise a great round and nothing really happened. If things go down, more options are on the table with more runway and down rounds are less likely with more time to grow the business.

3. Growing capital efficient can be an asset. Knowing what increases profitability while growing a company increases room to maneuver to also increase runway if sensible or required. Yet, the degree of efficiency should be a case-by-case decision. An economic downturn is also the moment to win a market. Hitting the breaks too hard while having great growth momentum doesn’t do anyone any good either.

[1] I am not including the Covid Dip in 2020 because recovery at least in our industry and for large parts of the digital start-up landscape was too quick to call it long lasting and fundamental

[2] For reference see GFK consumption index going down 27,26,28 and 31 points respectively in months May to August (August expected)

[3] Multiplying Growth Rate with the Multiple is a simplification to show effects. As a matter of fact, less growth will have a negative effect on the multiple and that is factored in here.

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