What happens to profitable companies when VC funding runs out?
There is no escaping the fact that funding has dried up in the tech world. In early April, The Financial Times reviewed the global funding drop in Q1 2023 and noted that besides 2 exceptional deals for OpenAI & Stripe, startup funding YoY has globally decreased by 63%. As the graph below shows, these funding levels are once again the norm, making the growth in funding in 2021–2022 look like an outlier.
The article concludes with: “Investors anticipate a wave of company failures later this year, as some start-ups run out of cash. The founder of one large Silicon Valley venture fund said: “Things are very, very tough.”
VC Michael Jackson added on Linkedin: “Venture investment has regressed to the mean, but some companies raised large sums of money in the frothy times to scale things like negative margins and other bad bits of unit economics, and now the music has stopped. There are a lot of bad venture-backed businesses now with absurdly high valuations”.
As many of us mourn the end of the good times, it is easy to leave a key question unanswered: ‘what happens to profitable companies when VC funding runs out’?
The short answer is… not much.
The longer and more nuanced answer likely comprises of the following:
1. No party, no after-party hangover.
When one grows a company on positive unit economics (cashflow, slow growth, expansion only after success etc), there is no after party shock. Valuations don’t skyrocket overnight to a unicorn but they also don’t crash when the market sentiment changes. If one is lucky enough not to have any VC on the cap table, not getting one in the next X months is not a risk, it’s business as usual.
Since team growth is always dependent on the last period’s success, funding dynamics are almost entirely absent in the discussion.
2. Recruitment is much easier.
Starting in May 2022 we noticed that recruitment dynamics completely changed, and every role became much more competitive (for candidates) and easier to fill. It is never easy to find excellent talent with high motivation for you, but it is not just that competition changed: the flavour of running a company profitably, the same one that meant we won’t ever make it to the top of the revenue growth lists, is suddenly in fashion. A bit like those 70’s outfits in one’s parents closet- profitable growth is suddenly in fashion again, and some candidates who have seen enough of what the other side often looks like — seek just that and are willing to move abroad or settle for lower terms just to join one of a few companies who combine scale, ambition and profits.
The table below tries to capture some of the differences between profit-led growth and VC led growth:
3. The same challenges that were always there are still there: execution, strategy, customer needs answered, new markets expansion, culture and morale.
Get any of them wrong, and you begin to struggle. Get all right, and you flourish. Micro changes in customer demand are barely meaningful to growth companies who (regardless) have <1% of their addressable markets. Only extreme events such as the first Covid-19 wave can impact the demand in noticeable ways, the rest is all execution determined or ‘noise’ in practical strategic terms. The same is not true for companies dependent on investment sentiment to hold or accelerate in order to have a future.
If you are looking into joining a startup today, how can you tell if that is a place where the music is about to stop or a company on the journey to building a long lasting, valuable business?
I would ask these questions:
- Did the company ever turn a profit? If so, when?
- Good answer: last year
- OK answer: for a month in the past six months, but we’re heading for profitability in the next X months
- Bad answer: we are profitable on the unit economics level but are a team of 200 FTE and have 6 months of runway left, but we are sure we will raise new funding now that we hit unit economics profitability…
2. What is the equity stake of the team net of liquidation preferences and is there an upside from the current valuation?
- Good answer: >10% of net, there is plenty of upside.
- OK answer: >10% but liquidation preferences would shrink it towards zero at current market dynamics. (This is not ‘good’ but at least you get honesty and hopefully the last round terms weren’t absurd)
- Bad answer: No equity to the team / What are liquidation preferences? / We last raised at 50X revenues
3. Looking around you, how many of your team members are likely to be here 3 years from now?
- Good answer: I hope all
- OK answer: Probably half
- Bad answer: I don’t think any of us is here for the long run, only the founders
These three questions often tell you everything you need to know because:
1) Good companies have already found their path to profitability as the funding music stopped about a year ago.
2) Good companies have not fallen over themselves to raise at unrealistic valuations. Doing so would have given all the equity upside to the VC and some of the founding team who sold secondaries when the round was done, making that unicorn headline which seemed so shiny to the average team member something completely different.
3) In good companies, team members know they will overcome obstacles and stay working with peers they appreciate for the long run. They will also reap the rewards they deserve in building equity value in their companies, as such companies remain valuable long-term in every funding environment.
If you talk to a company and get the feeling I just described — you are heading into a good place. If you feel short-term motivations and by this stage of the funding cycle , likely dashed hopes, stay away.
This was always true, regardless of the funding status, but it easier to spot now. The ‘short-term’ for poorly built companies is now very short and it is much less likely to happen to ambitious profitable companies.
This post was originally published on Vio.com’s Medium
