The reshaping of the venture capital landscape
"The era of easy money and non-discriminating investors is likely coming to an end," write Gal Gitter and Daniel Cohen of Ibex Investors
Over the last month or so, many of our conversations, be it with other funds, startups or other collaborators, have begun with a discussion on what the Venture Landscape will look like in 2022. The main impetus for these discussions has been, as you would expect, the sharp declines in valuations of publicly traded SaaS companies of late: The Nasdaq Emerging Cloud index has lost over 25% of its value in the last 6 months, with many significant names down by 50% or more. Multiples have reverted from record-highs back to their long-term trend: in fact, forward revenue multiples in high-growth cloud companies are now essentially back to where they were in mid-2019 or the first couple months of 2020.
How will this impact the venture and startup landscape in 2022? And how should this change or inform your startup’s perspective or strategy? Here are the main points that summarize our view.
1. Achieving hypergrowth is (still) your primary objective
With so much ambiguity around the public markets’ impact on the venture funding landscape, lack of clarity around future IPO windows, etc., we’ve been told by a number of startups that they have been advised to cut down on much of their growth related-spend and ensure they have enough cash to “survive the coming winter”. We believe that, for the most part (which we will get into in the next paragraph), that is very bad advice. Overacting to the current conditions in the public markets is usually the worst thing a startup can do: Remember, you are in the business of innovation and growth. When there is a “winter”, your best bet for survival is to focus on growth. Even if you have ample cash in your bank account, there are no guarantees that you will ever be able to hit your plan again if you divert from it now. The Venture landscape is still flushed with capital will be invested in the most innovative and highest growth companies. It may happen at a lower valuation than you are expecting, but it is still a much greater risk for your business to underspend on growth and thus miss your targets, than to overspend in order to maximize your ability to hit them. Companies with middle-of-the-pack growth rates will definitely have a much greater challenge raising this year — so you need to make sure your company is not one of them. Even in 2022 (or perhaps especially in 2022!), in the words of former Notre Dame Football coach, Lou Holtz: “There are only two states in life: You are either growing or dying”.
2. But not all ARR Growth is created equal
Regardless of how you generate opportunities today, you have likely seen your Cost Per Lead go up in 2021. We’ve seen this occur for most companies, specifically those operating in the Google and Facebook eco-systems. According to data from Skai, cost per click (CPC) has risen by more than 50% in 2021 for advertisers in paid search. So, you’ve been under massive pressure to grow but the cost to acquire each customer has likely risen.
When costs rise at a rate that budgets can’t always keep up with, it’s time to rethink your approach to growth. Teams must work creatively to reinvent and create new channels with the potential to grow into a bigger part of the mix in such a way that it reduces your weighted customer acquisition cost (CAC). The metric that tells this story is your LTV/CAC ratio, which compares the lifetime value of a customer (LTV) to the cost of acquiring them. You’ll know if you’re growing efficiently if your LTV/CAC hits 3–3.5x or higher. It is no secret that it’s easier (and cheaper) to upsell, cross-sell, and generally improve your relationship with an existing customer than it is to acquire a new one.
In 2022, traditional “acquisition addicted” models that drive growth via inefficient marketing campaigns will decline in importance vs. more efficient growth channels and investments in long-term customer value (i.e., churn reductions and upsell strategies). Simply put, we believe that the tradeoff between growth and efficiency will skew slightly more to the efficiency side in 2022 than in 2021. So perhaps you are better off growing at 150% with a 3X LTV/CAC than at 170% with a 2.3 LTV/CAC in 2022. Growing rapidly will simply not be enough in 2022 if it is inefficient at a gross or overall relationship level.
3. Profitability will matter again
There’s an old joke in venture about a VC having a great meeting with a startup, only to comment at the end of the meeting, “Everything is great, the only problem is that you are too close to being profitable.” For the most part, this has characterized the venture landscape in 2021, in which, if a company was growing rapidly, many investors turned a blind eye to a high net burn rate or poor (and negative, of course) EBITDA/Revenue ratio.
In contrast to that, we recently chatted to a growth stage SaaS company that is now talking to multiple funds about its future funding round. Their fundraising process started last year and continued into 2022 and thus has provided them with a glimpse into the initial differences between the two years. The company jokingly commented that the percentage of funds that have inquired or commented about their profitability has gone from zero in 2021 to nearly all of them in 2022.
Of course, this is just one company’s fundraising process and should not be extrapolated more broadly, but we do believe that companies’ profitability will matter yet again in 2022. This does not mean that growth stage startups should become profitable in the near-term. In almost all cases, that’s actually a bad idea as it will very likely come at the expense of your growth rate and ability to capture market share. What it does mean, however, is that you do need to monitor your EBITDA/Revenue ratio (and strive to improve it!) as well as chart a realistic path to becoming a profitable company in the future. Perhaps this will happen in 2024 or 2026, but if you are not building a business that can realistically become profitable, it is possible that 2022 will be more difficult for you than 2021 was.
4. Shrinking option values levels the playing field in hiring
If you ask any startup about its most difficult challenges in the last year, you will likely hear the words “hiring talent” about 10 seconds into their answer. This is of course a direct derivative of the growth and funding in the ecosystem in 2021, but it has also resulted in another related factor: the sheer amount of IPOs in 2021 plus the massive and sudden increases in valuation for many of those companies. Many of the employees in these companies have become millionaires on paper, with the value of their options providing the lion’s share of their compensation. The assumption was that this would continue, and thus employees joining these companies have valued their options as the main part of their compensation package, making it nearly impossible for earlier stage startups to compete for the same talent. Well, this has changed dramatically in 2022 and the last half of 2021, as many of the option packages provided to late-joining employees of these companies are now nearly worthless, given the significant drops in their stock price.
Earlier-stage startups can now more successfully compete for talent with the industry’s high-flyers, highlighting their options packages as the main driver. Recent IPOees are already significantly increasing the cash portion of the compensation packages provided to employees to combat this and simply retain their talent. In any regard, 2022 will continue being a brutally competitive year for talent. Though in contrast to 2021, the playing field will become much more balanced between public, growth and early-stage startups.
5. A year marked by IPOs will give way to more M&A opportunities
The number of IPOs and IPO deal value more than doubled from 2020 to 2021 as software companies took advantage of favorable market conditions and COVID-driven business tailwinds. As growth cools from the pandemic pull-forward, this has the counter-balancing effect of not only normalizing valuations but also driving M&A opportunities. High-flying growth companies are looking for what’s next to add new avenues to their trajectory. Startups that haven’t yet hit scale will be looking to join forces with larger, well-established platforms. Meanwhile, 2022 cash piles are as abundant as ever. Essentially, the roster of potential buyers has never been larger or richer and spans the gamut from large-cap tech to cash-rich growth (public or private, Israeli or foreign), to semi-autonomous subsidiaries housed within larger strategics (often themselves previously acquired), to financial sponsors. Each of these buyers has a unique set of motivations, so understanding them will enable you to position your business in the most appealing and potentially lucrative way. At the individual company level, it’s a tremendous opportunity for management teams, employees, and investors to maximize the potential for an M&A exit to be on the table, even if it has not been the primary goal of the company thus far. Thus, engaging with potential buyers in a commercial capacity, via cultivation of channel or product relationships is likely a great idea in 2022.
Overall, we believe the era of easy money and non-discriminating investors is likely coming to an end. Investors will demand high growth companies that have products and/or services that have a clear path over several years to generating real profits. We believe the last few years in the market were likely an aberration — and we should return to an environment where building a company that can ultimately sustain itself will be paramount.
Gal Gitter is Partner and Managing Director at Ibex Investors and Daniel Cohen is a Senior Associate at Ibex Investors