Be prepared for valuations and terms that are returning to pre-bubble norms
The new year has arrived and many early-stage startups are gearing up to begin fundraising. The timing is not great.
With the Nasdaq down 33% in 2022, high-risk stocks like Telsa down 75%, the SPAC boom dead, the IPO market closed, and later-stage startups taking down rounds, it’s a tough time for early-stage startups to be looking for money.
This is a complete turnaround from the beginning of 2022 when it seemed that every crazy idea was not only getting funded, but at insane valuations.
The slowdown started around the middle of last year. I’m an active member of two angel groups with member funds. Both groups typically invest 10% of the fund in 10 startups over the course of the year, and raise a new fund each year. This year, both groups are still sitting on most of the money raised at the beginning of 2022. We won’t be raising another fund for a while.
Internally, we’ve been asking each other: “Where are all the good startups?” “We haven’t seen anything worth investing in since April.”
We’ve seen just as many pitches, but made far fewer investments. Has the quality of the startups gone down? I doubt it. But our enthusiasm has, especially for marginal deals. A year ago, we were jumping aboard anything with momentum. Now we’ve sobered up and become more discerning.
What hasn’t changed yet are the deal terms we’re being offered. While the stock market has plummeted, the value of our homes is going down, and the interest we can get from cash has skyrocketed, the deal terms I’m seeing from early-stage startups are still where they were a year ago at the top of the bubble. And that’s causing a mismatch between investor and founder expectations that’s preventing investment.
From 2010 to 2018, a typical early-stage startup raising a pre-seed round might’ve had a valuation of $6M. The same startup pitching in 2018–2020 would’ve been valued at $8M. Then in 2020–2022, the valuation jumped to $10M, if they offered a valuation at all instead of an uncapped note.
Other investment terms similarly became more founder-friendly during the startup bubble. The amount raised by the typical early-stage startup rose from $500K to $2M while investor protections such as board seats and liquidity preferences disappeared.
As investors, we held our noses and accepted unfavorable terms because everyone else was doing it, and if we insisted on better terms, the founders moved on to other investors.
The startup funding boom seemed great for founders while it lasted, but attractive terms in early rounds are counterproductive, storing up trouble for later. Many of those same later-stage startups are now looking at down rounds or being shut down completely.
The way forward is obvious, if painful. Investors are still looking for startups to invest in and bemoaning the lack of attractive deals. Startups are looking for funding and bemoaning the lack of investors. The only thing missing is agreement on terms.
Large, liquid markets like stock markets and commodities self-correct with millions of transactions every day. The going price of a share of a public company or an ounce of gold is always clear. Real estate is less transparent since every property is somewhat unique, but there are hundreds of transactions in every neighborhood each month, all of which are public information, making it possible to estimate the value of any property with some amount of accuracy. Real estate agents who know the neighborhood help guide buyers and sellers on what terms to expect.
Startup investments are much tougher. There are few transactions, and the terms remain confidential. Each startup is truly unique, with valuation based on complex variables including founder experience, market opportunity, and customer traction. The only way to estimate a startup’s valuation is to talk to investors and read articles like these.
So here is my advice if you want to be funded in 2023.
Forget about the valuations that friends and cohort members were getting in 2018–2022. The bubble is over and we’re back to fundamentals.
Your early-stage startup that might have gotten a valuation of $10M last year is now valued at $6M in 2018 dollars. With inflation, let’s call it $6.5M. Assume your current valuation is 35–50% below what you thought it was.
Similarly, the amount you planned to raise should probably be cut in half. Look carefully at how much you really need to reach the next major milestone in 12–18 months when you can raise the next round at a higher valuation.
Those “we’ll agree to anything” terms are gone, too. Investors are back to expecting the terms we saw in the old days of pre-2018. If you want to bring in investors, you’ll need to offer:
- An attractive valuation or valuation cap. No uncapped notes or SAFEs.
- A real board, including a board seat for the lead investor, and perhaps a board observer role for a second large investor.
- Liquidation preferences of 1x or higher.
- If major milestones are being promised in the near future, warrants are required to adjust the valuation down if the goals are not met.
- Warrants for earlier investors in the round to provide an incentive not to wait.
- A plan to do more with less, including lower salaries and hiring far fewer staff.
Now, more than ever, investors are taking a harder look at deals to assess the risk vs. reward. To rise to the top of the pile and attract investors, you’ll need to show the fundamentals:
- A world-class team with domain expertise and experience building a startup
- Customer traction to prove the product solves a real need
- A strong moat to keep out competition
- A large enough market opportunity to generate a huge exit
Like most things, the current funding challenge is also an opportunity. When investors were throwing money at everything, every good startup immediately attracted 10 competitors with slight variations on the original idea. And with so many startups getting funded, it was impossible to find needed talent. Now with less water and fertilizer, the best startups have space to grow without being strangled in weeds.
The best startups will still have investors lined up at their doors with checks. But even the best will have to offer more attractive valuations and investment terms than they may have been expecting.