If you are participating in the startup ecosystem in any capacity, you are more than aware of the drought in the funding markets over the last several quarters. Amid the COVID boom, startups were raising enormous amounts of money at unprecedented rates. Then, seemingly overnight, public equity markets came to a screeching halt in November 2021. It didn't take long for this fear to trickle down into private markets. First, later stages froze up - think series C and beyond. Then eventually series A and B also came to a near standstill by the summer time -- which happens to be when we at Mad Rabbit kicked off our raise, of course -- and we can see it in the data from Cooleygo:
So, what is the current state of the market?
Public equity markets have looked good YTD with the S&P up nearly 6%, and Invesco QQQ up nearly 20% at the time of this writing. Growth stocks that got clobbered during this bear market are also performing; $FB up 65%, $ROKU up 56%, $CVNA up 85%, and others.
Public markets look relatively positive. I can speak to my own perspective on the state of the private markets having just announced Mad Rabbit’s $10M round that we spent several months in the market to get done.
Over the past several weeks, we are seeing some signs of life in the early stage markets, including;
It is definitely hard to know how ‘founder friendly’ any of these deals are, but regardless, I find it encouraging that there have been several 8 figure rounds announced in rapid succession over the last several weeks. My hope would be that this signals a bottom in the market, and that founders have finally gotten to the point where they are willing to supply terms that the investors demand.
The one caveat is that it is hard to know exactly when these deals closed, but I suspect that they all mostly closed either right before the holidays or shortly after. Either way, we are seeing more investors come off the sidelines and fund businesses with real potential, which leads me to my next point.
This is the biggest distinction from 2021/2022 to now. Over the last several years, there was so much money sloshing around the ecosystem that pretty much anything with a smidgen of potential was getting funded, and often at absurd valuations. The biggest shift in markets today is that companies that deserve to be funded, and have real long term earnings potential, are being funded. This will cause a controlled burn of all the less sustainable companies that are only still around because of the frothy funding environment of the last couple years.
So that begs the question, what makes a company attractive to capital? I can speak on this firsthand after having spent my fair share of time in market getting Mad Rabbit’s recent equity round closed. These 3 key points apply primarily to early stage (seed, A, B) consumer businesses.
Point 1: Healthy growth is attractive.
You don’t have to be an Ivy League economist to understand that growth at all costs is out of style in this market. That is not a dig on those who found success on the path, once upon a time, that was what the market wanted. Today, investors are much more concerned with the underlying fundamentals of any business driving the growth. This comes down to a couple of components.
So, in short, you need healthy growth.
Point 2: A business' omni-channel potential is a green flag.
I could and probably will write about why DTC is not a sustainable business model (in 90% of cases) in another post, but for now, just hear me out. In the eyes of the investor community today, you can prove a concept online, but it's extremely hard to build a business online. After all, ecommerce is still much more nascent than people tend to remember; with online sales being still meaningfully less than 20% of the total economy.
If you are a business that probably won’t have a spot in Walmart, Target, CVS, Walgreens, GNC, Vitamin Shoppe, any major apparel retailer, etc - you are not going to have a fun time in the equity markets today.
This comes back to the notion of profitability. In short, retail is no longer the middleman, and retail channels actually prove to be much more profitable than online channels.
Point 3: Team quality is critical.
Team has always been important. However, I believe this to be worth calling out as it is especially important in a market as dynamic as the one we find ourselves in.
Founders need to respond to market conditions. After all, venture investors are investing into companies that they ultimately will believe to exit to some sort of acquirer, be it strategic or financial. Therefore, the management team behind the wheel needs to be aware of the state of the market and building in accordance with what is in demand. For instance, there was a massive shift in demand to profitability, and the management teams who thought they were going to continue to use growth over profitability in order to attract capital have been punished severely. There are two rules in markets; 1) don’t try to time them and 2) don’t try to tell them what they want.
Therefore, founders who responded to obviously shifting market dynamics by reducing burn and reeling in operations were rewarded by the capital markets with the most precious gift in startups: time.
Another characteristic of the current state of the market that I believe to be under-appreciated is that there are a lot of investors under pressure right now.
Imagine this - you were an investor that raised a fund in 2019. You deployed capital aggressively into the hot sectors; Consumer, FinTech, SaaS, etc. Your fund was marked up 5x on paper by 2021. You did not return any capital to your LPs (those who gave you the money for the fund). Come 2023, your fund is now marked down huge amid declining valuations. Your portfolio companies are struggling and you are watching all your paper gains disappear. Your LPs call you and they are furious, asking why you didn’t sell and return their capital.
On that phone call, would you ask them for more money? Probably not. Therefore, a lot of investors have bee, and still are at a standstill. Many funds have to ‘call capital’ to the fund to make investments. It is a lot harder to call for someone’s capital after you have lost some of it already. These makes it difficult for the buy side to create a bottom in the market.
In short, a lot of investors are timid, frozen, or frankly illiquid.
Obviously in the down market, term sheets have gotten much more aggressive. I don’t think that is news, however what I think will stick from here on out is the downside protections that investors were more than willing to forego over the last several years; namely the liquidation preference.
For a while there, investors were will to take maximum risk in an effort to participate in what seemed like potentially limitless upside. Now, term sheets have somewhat ‘come down to earth’ as the balance of power shifts back to those with the capital. Massive funds with fantastic track records have been completely wiped out because of the lack of these downside protections (among many other things). I expect that we will see deal flow recover, but terms will provide investors with adequate protection.
What this means for founders - do not go out and raise equity capital in this market unless you absolutely have to. It is not a good feeling to be out in these markets right now with your gloves off as all of the power is in the hands of the capital allocators. If you can, it would be wise to wait until the market has recovered more and we are back to a somewhat state of normalcy. Valuations are still in the toilet and I have seen many assets trade for 1x sales, and sometimes even lower. Hold onto your equity, weather the storm, and come out the other side stronger.
When we consider the price action in the public markets, the Fed’s recent sentiments, accelerating deal flow, and other macroeconomic indicators, I do believe that we have seen the worst in the startup funding markets. It is probably a tad bit premature to label this as an official prediction, but a lot of investors did in fact raise very meaningful funds in 2021/2022, and that capital does need to be deployed over the next 12-24 months.
A lot of investors are investing today. 9 months ago, I was trying to pitch investors who were very up front about the fact that they simply were not in a position to invest at that time, not for any reason other than the fact that they needed to let markets play out. It seems like a lot of dust has cleared and that investors are slowly coming out of the woodwork in order to try to get allocation in the best deals. I anticipate that many more investors will begin feeling much more comfortable in the second half of this year and that there will be decent increases in deals getting done in our lower private markets.
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