Big Tech is in tailspin: How startups get out alive

TL;DR: Lower valuations in Big Tech are trickling down to the startup world and hampering investment. As VCs get stingier with funds and valuations, some startups must shift to bootstrapped business models to survive a chilly market.

Investors are pulling back in big tech, causing carnage in the startup world. Famous late-stage firms are reporting record losses, layoffs, and hiring freezes. 

“Investors put 23 percent less funding into startups in the second quarter [of 2022], following a 20 percent drop in the first quarter,” according to Inc.com.

Instacart lost 40% of its value in early 2022, Google slowed hiring for the second half of 2022, Coinbase laid off 18 percent of its staff in June, and Netflix announced layoffs and hiring freezes after a rough first half of the year. Meta, Salesforce, Peloton, Calm, and LinkedIn have also joined the growing list of big tech companies making significant cuts.

Early-stage startups are also feeling the pain. Decreased public-market tech valuations have repriced forecasted exit values for startups at all stages. Smaller exit prizes have raised the bar on expected risk-adjusted returns for VCs, meaning fewer companies are making the cut to close a round. And startups that do make the cut are facing lower valuations.

As a startup consultant, I’m seeing this anxiety-inducing shift firsthand in my clients and my network. It’s inspired me to write about the current environment and give guidance on forging a path to survival for startups struggling to get funding. The path: Thoughtfully pivot to a profit-driven model, at least temporarily.

In this post, I’ll cover the shift in VC investing attitudes and the essential differences between bootstrapped companies and VC-backed companies. In future posts, I’ll share strategies a startup can use to pivot to a profit-driven business. 

VC investing attitudes have changed

In the past, non-financial signals like signups or founder reputation were enough to bring VC funds to seed-stage startups. Startups are currently telling me that even early-stage teams are now being asked to show significant sales and big-name customers, which used to come into play only at later funding stages. 

Lower valuations also mean that down rounds will be rampant, even for companies that show sales traction. The pressure for bigger returns on invested income should also increase since lower valuations mean startups need to do more with less capital to get VC’s classic 10X return requirement.

In some ways, this environment can be a good thing. It focuses investment on companies that show genuine, immediate promise. The higher bar could result in fewer swindlers, crypto frauds, real-estate companies disguised as tech companies, and other money-wasting fakes.  

At the same time, this chillier investment landscape has a high cost. More risk aversion from VC can stifle innovation and quash business ideas requiring too much ramp-up. And even for the best startups, lower valuations can steal value away from founders who will need to part with more equity for less cash. 

Hesitant investors can also catch current investor-backed companies in the lurch. Some companies expecting to go out for their next round of funding this quarter are being told to wait until 2023. But how do they support their current burn rate in the meantime?

Given changes in investor sentiment, many startups across the board will be forced to change strategies. Learning to go it alone permanently or even just for a few months means they’re shifting from an investor-backed model to a profit-driven or bootstrapped model.

How VC-backed startups run: The Leap and Reap model

At a high level, VC-backed companies grow their business by taking big bets using investor money. They make bold investments upfront based on the idea they’ve pitched. They earn lots of money after making that investment if things work out. If things don’t work out, they don’t earn significant profits, and investors lose the money they invested. It’s what I like to refer to as the Leap and Reap model.

Spending and earnings over time of a successful startup running this model could look like this:

VC-backed startups Leap by making a bold investment early on. In this model, you see this investment happen in period 2. After this investment, the startup initially loses money and has negative earnings in periods 2 through 8. The company may be investing in hiring, buying important assets, creating a product, marketing a product, etc. If things go well, eventually, all that spending pays off, and the startup starts earning lots of money. In this model, you see this beginning to happen around period 9. These earnings are the Reap - when the startup and its investors enjoy the spoils of a successful investment, eventually earning a Return on Invested Capital (ROI) that exceeds 10x.

As a quick aside, it’s important to note that this is a simplified version of how VC-backed startups spend. Most startups - both VC-backed and bootstrapped - continuously iterate on ideas and don’t necessarily spend all their investment all at once upfront. Additionally, many startups spend more consistently, and some have a very long burn period before turning a profit. Those taking multiple rounds of funding may immediately reinvest earnings in future growth. Cash flow can vary widely.

However, the salient point of VC-backed investment behavior is that speed and very high returns are the priority. VCs expect a 10x invested capital return over 5 - 10 years. To get there, VC-backed startups need to spend and iterate more quickly than bootstrapped companies. They are motivated to take bigger risks to access greater rewards.

How bootstrapped startups run: The Earn, Burn, and Learn model

Bootstrapped companies are wired differently. They grow with limited resources and don’t have significant cash to invest upfront. They focus primarily on making profits, only increasing spending when accumulated cash allows, and quickly defunding ideas that don’t translate promptly to increased earnings. They use what I like to call the “Earn, Burn, and Learn” model.

An example cash flow diagram of a startup successfully using this model could look like this:

When a bootstrapped startup starts, its first priority is to earn money. It may require a bit of startup capital to get things set up, but unless a bootstrapped startup founder has a lot of money to fund the business, the startup will need to start earning profits to sustain itself quickly. 

For a service business, this might look like a small amount of money spent on incorporating the business, networking, and making a website, but then quickly finding a first client whose revenues promptly exceed those expenses. For a product-based business, it could be a small initial investment for your first run of inventory, which you quickly sell out of, earning a profit. You see this tiny initial investment in the above model happening around periods 2-3.

As a bootstrapped startup continues to operate profitably, it Earns, meaning it accumulates money. You can see this happening in the model around periods 3-13. After some time, these earnings may amount to enough money that the startup founder now has the power to re-invest some of that money back into the business. If she does so, she’ll be deciding to Burn.

Deciding to invest earnings back into the business or to Burn could mean a founder decides to create a new line of products or hire more employees. And this Burn could be a one-time investment or an increase in ongoing monthly spending. In the cash flow diagram above, the founder decided to Burn in 2 ways: investing over $25k just before period 15 and increasing monthly spending overall in period 15.

The final phase of the spending cycle for bootstrapped startups is the Learn phase: After a founder decides to reinvest in her business, there is the opportunity to examine the outcome and determine if the investment paid off. If it doesn’t, there may be the opportunity to de-invest, scale back, and revert to the old profitable business model to rebuild earnings and try again tomorrow. In the example above, the investment paid off. After a considerable investment around month 15, the business takes off! Earnings exceed pre-investment earnings and increase at a faster pace than before the investment. 

Making a strategic shift

While the nuts and bolts of your business will need to be adjusted to shift to a bootstrapped startup model, the most crucial shift starts with your business mentality. 

This perspective shift isn’t easy to make. Changing to a bootstrapped model can feel ‘boring’ to risk-loving VC-backed startups and founders. The big moves they're used to driving just aren’t feasible anymore without investor cash. Generally speaking, the kinds of people who opt into being founders of high-growth companies aren’t the same people who are motivated by making careful, disciplined moves using limited resources.

The change comes with a big learning curve. Company-wide goals and closely-monitored metrics will need to be reset. You’ll need to measure and monitor efficiency more closely and methodically. Startups must re-engineer coordinated activities throughout the team when some roles inevitably get cut.

Recalibrating the pace and rhythm of growth in a company requires a fundamental cultural shift that needs to permeate every aspect of the business. Companies who want to shift to a bootstrapped model need to start thinking about earnings driving future growth instead of depending on VC funding to create momentum. 

Some startups can’t pivot to profit

While temporarily transitioning to a bootstrapped model may help some startups survive a slow investment market, some startups don’t have the option to shift. 

Companies that require significant, long-term investment to get to a viable product cannot survive if they can’t get funding. Drug companies, bleeding-edge hardware, or anyone relying on investor dollars to win a market might be unavoidably destroyed if they can’t connect with investors.

For these companies, there are a few options. Some will be lucky and promising enough to get funding, regardless of the funding environment. Those that do should be weary of giving away too much equity with a deflated valuation. If they’ve already closed a funding round in the past, they may be able to do a bridge round (sometimes called a “seed-plus” or “series A plus” etc.) using the valuation from their previous raise.

Others may have the option of pausing development, carving off a more immediately sellable product, or finding alternative funding options.

Making a plan for your startup 

If your VC-backed company is running out of funds to burn, transitioning methodologies company-wide might be the way to get through rough seas. But how do you make the switch? 

In future blogs, I’ll explore this issue from a couple of angles, including what and what not to cut, approaching from the P&L, and more. Stay tuned!

Is your startup struggling to get funding and figuring out how to survive a chilly market? I’d love to hear your thoughts! Share your comments below or by reaching out to info@laurenpearlconsulting.com.