Written by: Joshua Siegel | Acronym Venture Capital
From mass layoffs to rising interest rates, venture capital is entering a uniquely challenging environment.
Yet, with crisis and chaos comes opportunity, and this type of economy is also ripe for innovation.
Great companies are often born from recessionary environments. We saw that in 2000 and again in 2008/2009. The reason? When big tech companies reduce a large percentage of their workforce, it creates an opening for talented people to go out and start great businesses. But that also creates more competition at a time when investors are largely taking a wait-and-see approach.
So, what does that mean for funding? At the seed stage, the investment cycle will continue to get longer. Previously, investors waited roughly 12 to 18 months between rounds, but now that timetable has stretched to about 24 months and rising, as most VCs are taking their time, waiting to see that companies can generate at least some modicum of revenue to prove out a minimum viable product. In Acronym’s case we look for at least $1 million in annual reoccurring revenue, which is different than an annual run rate. We want to see consistency in customers.
Meanwhile, deal terms are getting tighter, and valuations are getting lower, which is what should happen in a less-liquid environment. Founders, however, are still clinging to valuations of years past and while the bets founders might be able to garner a premium valuation, most companies are actually started by first time founders and thus need to grasp reality.
We’re already seeing a slowdown in market activity. In the fourth quarter 2022, US VCs raised just $20.6 billion, and that dropped even more as in Q1 2023, US VCs only raised $11.7 billion, which means even more tough times are ahead for startups.
For startups, now is the time to slow down, hire only where needed, and cut product development. The days of easy money are long gone, and companies must show that they can live within their means. Markets will not respond favorably to businesses that are burning through cash too quickly, nor will they continue to plow money into companies that aren’t making money. The appetite simply isn’t there. But there is still a lot of opportunity across all stages.
When considering a potential investment, we view the opportunity through the lens of business, economics, and venture capital.
For a company to run successfully, it needs to make money to pay people and return a profit. Startups can only live off free money for so long. When interest rates were at zero, a lot of businesses could stay afloat despite serious shortcomings. But that’s not healthy. In an ideal economic environment, companies that aren’t running well should go bankrupt.
That’s why, when considering an investment, my job isn’t so much to identify and bet on successful companies. It’s about seeing into the future. Are people going to want these products/services in the long term? Are there products that would make an industry better and more efficient? You need to look five, seven or even 10 years into the future to when these companies enter maturity.
We see a lot of opportunity across almost every sector.
In fintech, companies are developing tools to make it easier to use and move money around and to prevent fraud and abuse—this will continue to be an in-demand segment.
Across hospitality, businesses are improving how they source and deliver food to the customer and finding innovative ways to root out waste; airlines and hotels are pioneering new methods of managing unused seats and vacant rooms.
Proptech is another exciting category. Our focus in this area is on software to assist in management and construction.
We’re bullish on the full spectrum of workflow technology, as machine learning and AI continue to push the envelope. The same is true for ecommerce, infrastructure, and logistics, with new tools and technologies that improve efficiency and save money. Ai is creating new paths for sales, customer service and even coding. It’s going to eat a lot of jobs.
During a market correction, there are potential opportunities in most sectors. However, we are wary of investing in four areas we call “MUSH”—or municipalities, utilities, schools and hospitals. And the reason is simple: All these areas have long sales cycles and are very inefficient with capital. Hence the returns for VC are limited.
How a company handles a challenging situation will tell you a lot about its value. It’s sort of the equivalent of Darwin’s theory of evolution but for business. During COVID, we saw a lot of companies manage difficult situations and come out stronger for it.
Take Easyship, a cloud-shipping service for ecommerce businesses. Like other logistics providers, Easyship had to navigate work stoppage during the early part of COVID. But the company was able to successfully manage the uncertainty, staying within its means and reducing office space, and, today, it is producing healthy profits with hundreds of thousands of customers serving more than 220 countries and regions around the world.
In boom times, it’s easy for companies to raise money despite their flaws. But these problems are laid bare in a tighter market. As we contend with a market correction that is likely to last for another two years, investors and founders should focus on companies with strong fundamentals that have proven they can both generate revenue and live within their means. And that goes for venture capital funds as well. If you run out of money, you’re no longer a VC.
Joshua Siegel is general partner at Acronym Venture Capital.