Daniel Nussbaum
Daniel Nussbaum
Posted on
September 30, 2022
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How to think about the equity market shift: a founder’s guide

How to think about the equity market shift: a founder’s guide

“The boom times of the last decade are unambiguously over,” Lightspeed Ventures declared earlier this year. Similarly, Sequoia announced that “growth at all costs is no longer being rewarded.” The message from venture capital firms is clear. After over a decade of focusing on revenue growth, the emphasis has shifted to profitability with sensible growth.

This shift in focus is happening alongside a general pullback of the public equity markets.  According to Crunchbase, VC funding in May was down 20% YoY and 14% MoM. Crunchbase also found that median round amounts have also started to drop compared to the second half of 2021. Funding is still out there. May 2022 was a strong month in terms of VC funding compared to 2020 and funds still have a significant amount of capital that they need to deploy. But, companies will have a more difficult and longer process to raise capital and, if successful, they will suffer more dilution.

Founders will face tough choices in the upcoming months about how to navigate this new funding environment. The approach they should take is heavily influenced by their company’s cash position and runway. The actions to take depend on a concept Y Combinator calls default dead or default alive. The question to ask is simple:

“Based on current cash, growth expectations and expenses, will your company be able to reach profitability before it runs out of money? If the answer is yes, your company is default alive. If not, your company is default dead.”

Steps for Default Dead Companies

Being default dead does not mean your company is dead. It just means that based on the current path you will need to raise funding to survive. Given the change in equity markets, raising funding is no longer a given. Here is the steps a founder of a default dead company should take:

1. Extend your Runway:

Go through your expenses and figure out what the ROI is for each of them. The cost of capital has gone up, so some expenses that were sensible to make 6 months ago are not now.

2. Focus Investments on High Unit Profitable Initiatives:

While cutting expenses is important, you can’t cut your way to profitability. Focus your investing on growth that is sustainable and sensible. This means cut investments that have long payback periods. Those may have made sense when the focus was solely on the top line, in other words revenue growth. Focus investments on items that will improve your margin profile and push forward the date you reach profitability.

3. Start Equity Fundraising Conversations Early:

If you have done the first two steps you will have aligned your company towards what VC investors are now looking for. However, the process will still be more difficult than the last time your company raised money. Start conversations early. Reach out to your existing investors and see if they have interest in doing an insider round. If your company is default alive you will need a capital infusion to survive. Do not assume this downturn will be short lived. Prepare for the worst and kickstart your fundraising efforts now.

4. Look into Alternative Funding Sources:

As a founder your priority should be getting to default alive and ensuring your company will survive. Given the equity markets pullback you should research alternative finance sources, outside the traditional equity market. Over the past few years there has been a growth in venture debt funding and revenue based financing companies like Capchase. At a time of decreasing valuations and increasing dilution, non-dilutive financing options become more appealing. However with the rising interest rate environment some of this financing may have also become more expensive (at Capchase we haven’t raised our rates, despite the rise in interest rates).

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Steps for Default Alive Companies

The advice for default alive companies has a lot of similarities with those for default dead companies. Default alive companies should still analyze expenses to determine which represent a good use of capital given the new environment. Default alive companies should also focus on unit profitability. The switch from growth at all costs to durable and disciplined growth is still critical.

The key difference for default alive companies is that they are in a strong financial position. As Winston Churchill said “Never let a good crisis go to waste.” It is frequently mentioned that some of the world's largest companies emerged after a crisis. While competitors cut investments and try to rectify their financial position there is a chance to gain market share cheaply and efficiently. Default alive companies can be opportunistic and grow sustainably due to their competitors pulling back.

To be able to capitalize on this opportunity and support this disciplined growth these companies may also need to raise capital. They will likely face similar issues in the equity market and have to suffer large amounts of dilution. Alternative financing options like Capchase should be particularly enticing to fund their expansion without sacrificing upside.

So, in summary, the goal for founders should be to get to default alive. That means cutting burn and raising capital if they can. For founders that are already default alive, the increased focus on profitability is still important. But they also should use their financial advantage strategically so they emerge out of this crisis stronger than their competitors.

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