In May, startup accelerator Y Combinator (YC) warned its portfolio companies that venture capital would dry up due to increasing interest rates and a slowdown in global economic growth, advising them to plan for the worst. YC, which invested early in Airbnb, Coinbase, Dropbox, and Reddit, encouraged startups to cut expenses and extend their runway during the reversal of a thirteen-year bull run. Therefore, this is a time for startups to return to the drawing board and revisit their game plan to assess how to best navigate the current funding climate and survive.
Other warning bells have been sounding off in the past few months, with many venture capital (VC) firms encouraging their portfolio companies to proactively face the current downturn. Sequoia Capital warned that rising inflation and continued geopolitical tension create a recipe for a “crucible moment” in a note with a more pessimistic tone than its ‘RIP Good Times’ presentation sent to partners in 2008.
The figures seem to justify this sense of pessimism, with VC funding in the second quarter of 2022 falling by 27 percent compared to the previous quarter, taking funding back to 2020 levels. The period of easy money, where VC funding shattered records in 2021 and grew 111 percent to reach $621 billion, appears to have ended—at least for now. Data from business analytics firm CB Insights shows that late-stage companies have been hit the hardest, with their funding contracting by 43 percent between the first and second quarter of this year. As a chart from Fortune shows, the most active VC investors have all scaled back their investments in the second quarter of 2022.
This retraction in funding is taking its toll on employees. According to industry tracker Layoffs, Sixteen thousand tech employees were laid off in both May and June. So how can founders take on the challenge of operating, and, possibly, growing their startups in this challenging environment?
A natural alternative when venture capital is unavailable is turning to bootstrapping, as it can extend the company’s runway until investors return to the table. Bootstrapping, where a founder uses their capital and reinvests the company’s revenue into its operations, is best used when product market fit is already achieved. In that scenario, internal capital can be used efficiently in funding operations as opposed to earlier stages, where marketing dollars and development resources are used to find that niche market fit.
For bootstrapping to be a viable alternative, cash flow must be strong enough to keep the company above water during a time of no external funding. This tends to be difficult in very early stages, when a company still understands who its core customer base is. However, once the company has built a recurring customer base and developed stickiness, then cash flow can be considered healthy enough to be an alternative to external funding.
An important note to keep in mind is that, without access to VC funding, a startup is missing out on the possibility of achieving accelerated growth in line with the hockey stick chart that most pitch decks promise. However, not all hope is lost, as this gives the founder a chance to focus internally on streamlining operations, resolving pain points, improving customer experience, and further developing the company’s offerings.
Drilling down on streamlining operations reveals a few areas where a company can rationalize costs without jeopardizing the continuity of its day-to-day activities. Office space is one of the first areas companies can rationalize without negatively impacting operations. The past couple of years have shown founders that remote—or hybrid—working models can be a viable option that is not disruptive and can even improve productivity when used correctly. During times when external funding is scarce, companies can manage their expenses by reducing office space and introducing remote work where suitable.
Customer acquisition cost (CAC) is another important factor founders need to consider when deciding whether bootstrapping is the appropriate route. During the early stages of a startup or when customer stickiness is very low, the cost associated with acquiring a new customer tends to be high. This is because marketing spending is closely correlated with the number of new customers being acquired, and decreasing marketing spend can immediately impact growth. However, when product market fit is reached and customers are familiar with the product or service, then CAC starts organically decreasing. Without a low level of CAC, it becomes very difficult for a startup to rid its reliance on VC money.
Even with CAC at lower levels, founders might notice that bootstrapping alone is not enough, and it needs to be coupled with a change in the direction of the company. This shift can take the form of pivoting or drilling down on a single business line. Identifying a possible pivot route or a part of the business to drill down on can allow the founder to operate with minimal VC funding for the short term. This should be assessed based on what is a reasonable pivot that uses the company’s resources or what is a business line that is much more successful than the others.
From a macro perspective, investors still believe that venture capital should remain part of their portfolios despite the current downturn. London-based consultancy firm Hardman & Co. published a white paper utilizing standard asset allocation methods to illustrate that most portfolio allocation strategies include a share of venture capital, as it improves their risk/return profile. The paper notes that institutional investors should carve out part of their portfolio for venture capital—ideally, between 8 percent and 13 percent. This could improve returns by 0.5 percent to 1 percent per annum without changing portfolio risk levels.
The key observation is that venture capital acts as a diversifying asset class in the investor’s portfolio. On a micro level, the success of the venture-funded startup depends on whether it can develop its product, build a customer base, and scale up the business in an expedited way. Achieving all of this is no easy task, and is why some investors have historically been shying away from venture capital as an asset class.
That is changing, however, as investors and asset managers with different risk appetites are starting to steer away from the view that high-risk investments are for high-risk investors only. As the Hardman & Co’s paper notes, if an asset—in this case, a portfolio of startups—diversifies the distribution of the portfolio, then adding a small percentage can improve returns.
Therefore, the good news for founders is that more players can potentially either enter the VC space for the first time or increase their allocation to this asset class. Sovereign wealth funds, private equity firms, and corporations are allocating a portion of their capital for this asset class while they receive direction from their limited partners to offer them an opportunity to participate in this vertical.
While VC funds are much more cautious in deploying capital (as the earlier data shows the drop in investment in startups), they are still raising funds to deploy this capital when the time is right and a suitable opportunity is found. Some of these funds are taking a more focused approach geographically, setting up the team to invest in areas they believe are ready for significant growth. Others are identifying winning companies that will come out of this downturn with larger market share and talent from their competitors that went under.
What is also happening is VC players are exploring different ways to invest in tech startups. In June, Saudi Venture Capital Company (SVC) announced its collaboration with investment firm Partners for Growth through an investment in its venture debt fund. This fund, which will invest in companies in fintech, healthtech, and life sciences, is an example of the Middle East’s exploration of new ways of venture funding. This follows the launch of the Middle East and North Africa’s first venture debt fund by Shorooq Partner’s in October 2021. Additionally, it sets the stage for increased interest in venture debt as an alternative to the typical funding method for startup through an equity-based VC model.
Further opening opportunities to invest in startups, crowdfunding platforms are gaining momentum and allowing retail investors to go hand-in-hand with VC firms. These platforms, allowing individuals to invest as low as $50, provide retail investors the opportunity to dabble in what has traditionally been somewhat of a gated community. At the same time, it can provide funding for startups that cannot secure support from VC firms. That theory will be tested with time, however, as it will be observed whether crowdfunding will become a reliable source of funding for founders.
So, what does this all mean for founders reading doomsday headlines about the future of venture capital? The fact remains that VC funding has slowed down this year, but not all hope is lost for startups. Founders can address this challenge head-on by pivoting, drilling down on a successful business line, or managing operational expenses. Moreover, the nature of venture funding is evolving, with new entrants that traditionally shied away from tech startups, as well as crowdfunding, venture debt, and other forms of participation gaining momentum.
What startups can also do is heed the advice of the Harvard Business School article published in 2020 that encourages them to think like camels, not unicorns. Camels can survive for long periods without food or water and adapt to extremely harsh climate conditions. Founders who can adapt to the current economic climate and survive long periods without their equivalent of food and water—VC funding—will be able to weather the current uncertainty.
Mahmood Abdulla is Senior Manager of Strategy and Planning at Al Salam Bank and Mentor at VC firm and accelerator Brinc.
Mon, Sep 20, 2021
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