By: Brian Burton, CFP®
- Cash-burning startups are being forced to take on increasing amounts of debt as VC funding dries up
- With funding slowing, fundamentals and profitability should return to the forefront of company evaluation
- The mantra of “growth at any price” that we’ve seen in recent years is likely gone for the foreseeable future
Last year was a historic one for start-up companies and venture capital fundraising as more money flocked into the space than ever before, even more than the dot-com bubble 20 years ago. Companies promising higher growth rates than those in public markets had investors pouring cash into the venture capital world to the tune of $330 billion in U.S. tech start-ups alone.
Earlier this year, there were more than 1,000 technology start-ups valued at more than $1 billion each (compared to 80 in 2015), with the majority far from profitability. The warning signs of a frothy market should have been flashing red when hot start-ups were the ones being pitched to by investors and not the other way around.
Along with this boundless flow of capital was a growing fear of missing out (FOMO) on the meteoric returns that some of the early investors enjoyed.
This FOMO led new investors to give start-ups more money than ever before, along with more generous terms. This behavior helped the venture capital industry to become bloated as investors put larger and larger amounts of capital to work, not just in a few individual companies, but across entire sectors.
Fast forward a few months amid economic uncertainty and an aggressive Federal Reserve fighting an inflation battle, and we find a tech start-up community that has been hit extremely hard. These sharp share price and valuation declines have turned venture investors away and led many of these cash-burning companies to take on increasing amounts of debt.
The problem is that, unlike equity investments, venture debt generally requires regular payments and has the potential to quickly make these cash-flow poor companies insolvent. On top of that, the financing options aren’t great in the current environment as investors are seeking much better terms across fewer deals.
Although we have seen many high-flying tech stocks including the Covid darlings, meme stocks, cryptos, and Special Purpose Acquisition Companies (SPACs) get crushed, the end result may not be so bad for long-term investors. This type of capital and risk repricing within a bubbly area of the market should return the focus to fundamentals and quality, allowing long-term investors to buy companies that are already leaders with the revenue and profitability to prove it – at a discount.
As for the start-ups, it will likely take showing greater financial discipline and maintaining an adequate standard of profitability because the days of growth at any price appear to be behind us.
