It's time for Australia's startup sector to brace for turbulence

I was in North America last month where I met with lots of investors and founders, across different stages and sectors, from around the region.

Some focused on early-stage consumer-oriented startups where they observed a pickup in the velocity of founder pitches for both novel and copycat businesses. Others were later-stage investors who observed that while big rounds for more mature startups were still being closed, a greater level of caution is being demonstrated by their peers, whether through longer due diligence processes, lower valuations and a desire to involve more investors in a round.

It’s understandable why uncertainty has crept into the market. Since the beginning of this year the S&P 500 is down 16%, with the S&P 500 IT sector down 23%.

Inflation has risen in many countries with the US running at 8.5%, Australia at 5.1% and New Zealand at 6.9%. Central banks have moved to cool their economies. The US Federal Reserve hiked interest rates twice this year from lows of 0.25% to 1.00%.

The Reserve Bank of Australia registered one rise last week from 0.10% to 0.35%. Meanwhile, New Zealand’s Reserve Bank has increased their cash rate four times since October 2021 from 0.25% to 1.50% last month.

While the higher inflation environment and tighter monetary policy, along with current geopolitical uncertainties, will impact the availability of capital across all markets, including venture capital, founders can still prepare to shore up their startups for success.

Reframe valuation expectations

When everything is going up at a rapid clip and there’s strong competition to get into a deal, valuations increase, and if a startup accelerates post-funding and improves its trajectory, securing an even higher next-round valuation is assured.

In an uncertain environment, valuations are likely to be squeezed. Instead of raising money today at tomorrow’s valuation, founders are more likely to raise money today at today’s valuation. The difference between these two valuations will depend on stage and traction of the startup.

For founders (and investors) wishing to avoid down rounds, there’ll be a greater amount of deal structure to maintain valuations.

Do more with less

Lower valuations lead to smaller rounds. If you undertake a larger round at a lower valuation, founders and existing shareholders will experience too much dilution.

Founders will need to adjust their business plan accordingly. Instead of opening in multiple markets simultaneously, they may need to open markets in sequence. Focusing on one product line may be better than splitting energies across two.

Withstand greater scrutiny

Demonstrating product market fit is often a challenge but those who do will be rewarded. Not only will they be building a business that their customers will help pay for, but they’ll be also more attractive in the eyes of investors.

Measures of product market fit vary based on the maturity of a startup. In the very early days, it may be pre-registrations, results of customer development interviews and letters of intent. Once the product is launched it may be daily/weekly/monthly active users, number of actions per user and time spent on site/application. As the product matures it may be detailed case studies, NPS score and churn rate.

Expect greater scrutiny of your unit economics. Do the direct revenues and costs of a unit of sale back out? What is the ratio of customer acquisition cost on lifetime value? What is the gross profit margin? What is the average order value?

Founders with high performing measures of product market fit and robust unit economics will be rewarded.

Preserve the balance sheet

Cash is the lifeblood of any business. While we’d all like for cash inflows to exceed cash outflows, when startups are busily gaining product market fit and growing it’s the opposite. That’s why it’ll be increasingly important to manage a startup’s cash balance or available runway. Businesses with greater runway will have more time to prove their case than those that don’t.

Difficult trade-offs will need to be made to preserve the balance sheet. A decision to bring on extra developers might be deferred. The rebrand might be shelved for a quarter. The timing for creation of an additional product might be adjusted. Whichever the trade-offs, it’ll be critical to demonstrate progress over this period. One of the first questions an investor asks is how much money has been raised before? They’ll want to understand your startup’s capital efficiency and what you’ve achieved.

Build for the long term

While the next period may be uncertain, founders who are building great businesses should be assured that there is capital to support them.

Most VCs, especially those with operator backgrounds, take the long-term view, and recognise that business, like life, is a cycle. It can take multiple iterations to achieve sustainable success, but the journey is worth the effort.