What? How? Why? The reasons behind the changes in the VC market
Recently, interest rates have started to rise rapidly in many countries around the world (such as the USA and many European countries, including Poland). This is the result of inflation caused by an increase in the prices of oil and natural resources, the war in Ukraine, as well as the increase in public spending, among other factors. The attitude of investors, who have so far been open to higher-risk assets, has changed accordingly. In the face of rapid changes in the markets, they have massively drifted towards less risky and more liquid investments.
It had started with the financial and cryptocurrency markets, but the change in sentiment affected the VC industry as well. In some geographic markets, it is clear that the flow of money from investors is slowing down. As a result, the funds will have less capital to invest and therefore achieve lower returns – it mainly concerns foreign funds, especially those based in the USA.
Polish VC funds have other investors, largely state-owned, and the global turmoil does not seem to have affected them as much. However, the global investment market has an influence over the trends and behaviours around the world, including in Europe. Polish companies should also prepare for a decline in interest from foreign investors, as foreign investments are generally perceived as riskier, especially if we are talking about emerging markets, which still include Poland. An additional risk is also the war raging on in Poland’s neighbour – Ukraine.
Not only is the rising inflation one of the causes of the crisis but also an additional risk factor. It brings upward pressure on wages and the cost of services, while at the same time making the cost of living and running a business higher, which in turn makes customers – both business and consumers – less likely to spend money. In this situation, it is more difficult for companies to achieve or maintain profitability. Under normal market conditions, the solution would be to look for larger investment rounds. In the current circumstances it is much more difficult.
Whoops! Am I in trouble?
For the founders, of course, this is worrying news – it should be expected that in the coming months it will be more difficult to raise new rounds, as well as achieve or maintain profitability.
Funds will not stop talking to start-ups and will carry on looking for investment opportunities, but they will certainly be pickier. Companies with stable streams of income and with cash reserves will have a better chance of obtaining funds. This is, of course, always true, not only in times of crisis. However, in an uncertain market environment, profitability and financial stability are even more important to investors – much more so than the prospect of postponed higher returns with higher uncertainty and risk.
The companies that are most attractive to investors are those that have adopted business models whose effectiveness has already been proved by the market (e.g. SaaS). On the other hand, businesses relying on products or models that have not yet proven their profitability and scalability, e.g. associated with the cryptocurrencies or metaverses industries, will be in trouble. Organisations that have already found their product-market fit will be in a privileged situation, as well as companies with unique technology that gives a lasting competitive advantage. They will find it much easier to convince investors to continue the financing.
How to react?
First, stay calm. As we have seen many times before, panic and speculation can cause far greater “crisis” damage than the economic mechanisms behind it.
VC funds will not give up on their investments completely. We should also keep in mind that there are also investors of other categories on the market, such as large corporations (e.g. car manufacturers investing billions in start-ups related to electromobility) or individual investors, as well as other sources of financing, e.g. crowdfunding.
Customers will continue to buy products and services that are really useful to them. Therefore, if so far there have been no assertions and signals suggesting the need to close down the business or bring about strategic changes in the business area, the current situation should not change this assessment. However, it is definitely worth conducting a level-headed analysis aimed at determining where we are as a business, where we are going and what funds we need to implement our plans.
It is also worth keeping in mind that every crisis is an opportunity. It is likely that a number of less prepared competitors will drop out of the market. There can be many reasons: failure to raise new funds, ineffective business model, negative impact of the difficult situation on their contractors. The other side of the coin is that there might be an opportunity to increase the market share faster, gain new customers and employees, or buy assets. It is worth being well prepared for such a situation as it can translate into large profits in a relatively short time.
Forewarned is forearmed
At the moment, it is still difficult to predict whether we will be dealing with a brief slowdown or a deeper and longer-lasting crisis. However, it is worth preparing for each of these scenarios.
The best starting point is always a financial plan and analysis of possible sequence of events. Each must take into account the resources available and the actions needed for further development, and of course the financial resources required for their implementation.
It may happen that the difficult situation regarding raising funds will last a long time. The worst-case scenario should therefore assume readiness for a situation in which the company will not be able to raise new funds for the next 24 months.
Managers and owners should therefore start with asking themselves where the company can get with the means it currently has at its disposal. In some cases, this may mean having to temporarily reduce expenses and scale of operations in order to survive the difficult period until it is possible to raise new capital again.
Reducing costs, extending the runway
It is best to prepare for such a development by planning to reduce costs and expenses. Let’s make sure we have a satisfying runway. If we can, let’s try to make it longer. Let’s consider:
- What level of monthly cash consumption can a company reach to continue functioning and developing at the same time?
- How much can you cut costs while maintaining operational capabilities?
- Which team members are key? Whose tasks can be delegated?
- Which business development projects will contribute most to building the company’s value, and which can be abandoned?
- What revenues are certain and what are probable? Is it possible to launch new initiatives that are likely to increase the amount of cash on hand?
Answers to these and similar questions will allow the founders to assess the importance of the threat and the possibility of falling on one’s feet.
Fast to the negotiation finish line
If we are in the phase of talks with investors that can be finalised quickly, it is worth taking advantage of it – even at the expense of some terms of the transaction.
Securing the company’s finances is more important than some of the terms of the investment agreement (for example, anti-dilution or liquidation preference). Negotiation of such clauses can take a long time, and sometimes even lead to failure of the fundraising process. So, if the future financial results justifying the increase in valuation are uncertain, it is better to close the new investment round quickly.
Be product-market fit
Founders of companies at the pre-seed or seed stage should verify product-market fit as soon as possible. Launching the product and seeing what customers think about it becomes a priority at this point. A solution that responds to the needs of customers should always generate revenues and, for both of these reasons, increases the company’s chances of raising new capital in difficult times. Keep in mind that in order to be able to reveal the product to potential customers and collect feedback, it does not have to be 100% ready.
Product-market fit is by far the most important differentiator and a key step towards credibility for companies looking for financing, and revenues are still the best way to provide the company with liquidity.
If not VC then what?
Founders of companies at the Series A stage should look at other financing options.
There are still many alternatives, such as issuing new shares for existing or new investors, debt financing (eg. bank loans, bonds, revenue-based financing), or EU grants. Each has its pros and cons and involves different responsibilities. It is worth checking them all in terms of availability, suitability, cost and requirements. They may turn out to be a much better solution than venture capital financing.
Crisis = opportunity
In times of crisis, new needs appear on the market. Customer preferences and the competitive landscape change. After securing basic needs and developing the plans we mentioned earlier, it is also worth preparing for these new opportunities.
Changes and turmoil create new needs and new niches. You don’t have to look far for examples – recently we have witnessed a sharp increase in demand, for example, for tools for remote communication and food delivery, caused by the pandemic.
So let’s keep our eyes and ears wide open so that during the economic slowdown we do not lose, but gain.