A change in macroeconomic conditions this year has prompted a wave of Twitter threads and online discussions about how important profits and cash flows are for early-stage businesses and venture capitalists have publicly acknowledged that their “growth at all cost” approach may have shown its flaws in the current environment.
The number of deals and the amount of funding that has flown to startups indicate that the VC market has been drying up as higher interest rates call for higher risk premiums and lead to lower valuations for early-stage businesses.
Moreover, investors may have pulled a portion of their capital out of VC firms and have moved to relatively safer investment vehicles as downward volatility has prevailed for most of the years on the back of a seemingly hostile macro backdrop.
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Could it be that venture capitalists are now truly focusing on looking for the most fundamentally strong businesses or is it just talk?
What Does “Growth at all Cost” Mean?
The main goal of venture capitalists is to exit the businesses they have invested in at some point. To do this profitably, they have to make sure that the company has been able to increase its revenues by a significant extent or they may also be favored if macroeconomic conditions improve as the exit multiple of their investment could also increase.
Say for example that the VC firm “ABC” invests in an early-stage business that is generating $150,000 per year in revenues. At this point, the business was valued at 1.5x its sales meaning that its equity is worth $225,000.
For the VC to make money, the easiest way to ensure a profitable exit is to push the business to the point that it can 10x its sales. If that happens and the exit multiple stays at 1.5x, the VC firm will turn a handsome profit.
This is the main reason why growth has always been prioritized by venture capitalists and why they tend to give money to companies that may have no clear path to profitability but that have already shown their ability to scale the business at a fast pace.
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Despite the Twitter threads and the lengthy discussions about this topic, it will be highly unlikely that this approach will change radically in the VC industry as it may backfire at some point.
For example, if VC firms prioritize profits and cash flows over growth, the number of deals may shrink and their portfolio will be more concentrated, meaning that its overall risk will increase.
The reason for this is that the number of startups whose path to profitability is clear is quite low compared to the elevated number of firms that have a large total addressable market (TAM), a solution, and a go-to-market strategy that can allow them to generate increasingly more revenues in the future.
Moreover, startups that are already profitable and cash-flow positive may not be investing their available resources boldly or wisely to keep expanding or their TAM could be too small, meaning that their ability to keep growing could be limited.
There’s Some Evidence That VCs are Slightly Tweaking their Approach
In a recent interview from TechCrunch with a group of individuals with ties to the venture capital industry, it was evidenced that some of these investors were reconsidering their approach after the recent weakness in the macroeconomic backdrop.
“Certainly investors at the growth stages are trying to ensure that if the hamster wheel of capital stopped, startups would still have sustainable businesses”, commented Latif Peracha, general partner at M13, an early-stage consumer tech venture capital firm.
Even though the “growth at all cost” philosophy may continue to prevail, other aspects of the business such as its ability to improve its bottom-line performance once certain revenue targets have been hit and a more controlled cash burn could be considered more important than plain stellar growth prospects.
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