Startups Success Rates And Repositioning For The New Normal
Looking back at the long economic expansion we just wrapped up, one can feel positively nostalgic. The amount of money invested in US tech startups has been breathtaking. Data from PitchBook Data shows that investments went from $35 billion in 2011 to $58 billion just three years later in 2014. In 2019 it hit $107 billion. Now comes what seems to be the great test for startups: surviving this pandemic and its accompanying recession.
We analyzed the outcomes for mature vintages of VC-backed startups, and between the data and our own observations, we’ve seen three notable findings:
- More money did not make it easier to build a successful startup. It appears the influx of capital simply funded more startups and gave them more money at steadily higher valuations. If you think of startups as experiments, then we ran more experiments rather than experiments that were more likely to be successful. Simply put: investing in startups has proven to fuel quantity, but not necessarily quality.
- In a recession, stage matters. Early-stage companies tend to be in survival mode because they have a small client base. Cuts to operating expenses are typically deep and swift. Mid- to later-stage companies tend to have a bit more breathing room. They can focus more on driving efficiency (such as improving gross margins and unit economics) and product development. That puts them in a position to restart growth when the economy picks back up.
- Prepare for a slowdown in fundraising. The flood of capital has meant less time between rounds. Coming out of this recession, we expect much longer times between financings to become the norm again.
Outcomes for US venture-backed tech companies
We wanted to capture the full range of outcomes for startups. So, we examined how companies started in the early part of the economic expansion, then watched how they fared over time. Specifically, we looked at startups that got seed or angel funding from 2011 to 2014 and studied what happened to them between then and now. We also focused exclusively on companies in traditional tech sectors in the US — as such, we excluded a range of startups in industries including beauty, oil and gas, health and wellness, and so forth. One remarkable aspect of this period is the increase in the number of seed-funded companies:. That number grew 58%, from 2,634 companies seed-funded in 2011, to 4,152 companies just three years later.
The data shows that even in the best of times, the “graduation rate” for firms able to raise subsequent financing has remained surprisingly consistent. For companies that raised their seed financings between 2011 and 2014, just over half (an average of 56%) were able to raise a subsequent financing round. Roughly half of those were able to raise another round after that. As you can see below, the startup graduation rate tends to be reduced by about half for each subsequent round of financing.
The rate at which companies in the 2011-2014 cohort have exited also shows how remarkably consistent things have remained despite the influx of capital. On average 8% of companies exited at the seed stage and another 6% exited after their next round of financing.
While the rate of acquisitions has remained relatively consistent, the volume has actually increased for seed and second-round companies, given the much larger cohort size for companies seed-funded in 2014. This increase in the volume of seed-stage acquisitions also makes us wonder about the implications for acquisitions going forward. If corporate acquirers or other private companies have built up their ability to do acquisitions, then it is reasonable to assume they might use the current downturn to their advantage. The shelter-in-place orders are favoring digital transformation teams at incumbents. Combining that dynamic with potentially lower pricing for underfunded companies could present a strong case for tuck-in acquisitions this year.
The good times have had relatively little impact on the failure rate of early-stage companies. The rate at which companies go out of business has stayed remarkably consistent as a percentage of the total number of companies.
Repositioning for this recession
So, what can companies do to increase their odds of success in this recession? How you reposition your startup obviously depends on a variety of factors including what’s happening to your customer base, how you sell, when you last raised capital, operating expenses, and available funding. But consistent with the data presented above, a lot depends on the stage of the company.
Early-stage companies are still finding and building their businesses. They don’t have a large, existing customer base or a well-established revenue stream to guide their growth. In this environment, it’s much harder to win over new customers than to simply focus on serving existing ones. With so much uncertainty surrounding customer acquisition and their ability to raise capital, their layoffs are much more dramatic than later-stage companies in terms of percentage of staff reduction. In this sense, the good times were indeed good for employees and the pursuit of growth in general. In many cases, early-stage companies have had to go from recruiting to downsizing.
Mid- and late-stage companies benefit from having built their customer base and having gone further down the path of refining their business models. As a result, they are cutting a lower percentage of employees than early-stage companies in this downturn. A strategy that we are pursuing is one of focusing on operational efficiency (as measured by their unit economics) while also investing in areas that can generate positive ROI in the next twelve months, whether that be a new product or expansion into an adjacent market. The goal of such a strategy is to increase gross margins and unit economics through efficiency so that when we do return to normal, companies can scale revenues profitably. Obviously, this depends on having enough capital available to invest in the team and technology beyond mere survival.
What do we expect in financing rounds going forward?
The implications from past downturns are both a tightening of capital and a move from focusing on growth to efficiency. Those companies looking to raise capital should expect that it could take significantly longer to raise their next round of financing. When we look at companies in the 2011 class, we see it took almost five years for startups to progress from seed financing (round 1) to their fifth round of financing. For the 2014 class, that same progression took just over three years. To put that in perspective, companies went from raising their next financing round every fourteen months to raising a round of financing every ten months.
When raising your next round of financing, you’ll be compared to the other companies that investors are seeing. The trends we see today indicate that we’ll see four broad categories of companies raising capital later this year and next:
- Top performers that continued to raise significant amounts of capital in 2020, including those companies that are benefitting from the current conditions
- Solid performers that will have performance metrics that are solid but have financials and cap tables that reflect the “reset” that is happening now
- Pragmatic companies that drove to profitability during these times and are out raising capital to accelerate their growth going forward
- Early-stage companies that did timely fundraises in late 2019/early 2020 and focused on product development at this time, and companies founded in mid-to-late 2020 by the grittiest of entrepreneurs
This downturn is offering a particularly strong test of the ability of entrepreneurs to drive towards successful outcomes. Though the times are certainly stressful, entrepreneurs have determination, creativity, and the ability to pivot quickly on their side. They are also benefiting from the longer-term trend of technology disrupting every industry, and in that regard, we expect that the distribution of startup outcomes will continue to be relatively consistent, even in these most difficult of times.