On October 21, 2011 at 10:20 a.m. I joined more than 8.5 million other Californians for the Great Shake Out, an annual earthquake preparedness drill. Four hours later, the Bay Area was jolted by a temblor that measured 3.9 on the Richter scale.
Even though we’d just been trained for exactly this scenario, many colleagues didn’t know how to react. A few panicked, others braced themselves in doorways and a number of people simply ran for the exits.
When the unexpected happens, no one knows how they will respond. That holds true in a downturn, too. Many first-time founders think they know where to look first to save money or how to pivot, but as the saying goes, no plan ever survives first contact with the enemy.
Basic best practices will not help your company endure this winter, so I invited M13 managing partner Karl Alomar to join me on a Twitter Space to discuss the following:
- Using “ruthless prioritization” to find proof points.
- Investors still expect “healthy growth.”
- Why founders need to secure 24+ months of runway.
- How to talk to your investors about pivoting.
- When it’s OK to leave money on the table.
- What you need to do differently to fundraise during a downturn.
Based on his time leading startups through the dot.com implosion in 2000 and the 2008 Great Recession, Alomar said it’s critical for founders to be strategic and not reactive.
To secure funding right now, you have to be a significantly outperforming business. Karl Alomar, managing partner, M13
Whether or not you feel like a leader, “the decisions you make in your business are going to affect all the people that work for you, so you have to be able to manage and communicate across all those stakeholders very effectively,” he said.
Using “ruthless prioritization” to find proof points
Alomar said M13 works with founders to identify “proof points” companies should execute against before raising their next round.
“There’s a difference between proof points, which are things that you have to build between rounds, and just validation of the business quality,” he said. These criteria vary but could include product-market fit, engagement metrics or specific initiatives that will help meet business targets like ARR or burn rate.
“If you’re a fintech business, you need to make sure there’s a good supply of capital. If you’re a hardware business, you need to make sure that the supply chains are clearly demonstrated to work,” he said.
In this normalizing market, Alomar said investors are searching for startups making “incremental” improvements so they can reduce their risk from previous investments. As a result, everything is up for consideration, including the makeup of the leadership team itself.
“There’s some businesses where you feel like the founders are just the right people to build it right up until it gets to true growth stages,” he said. “So if you just did a round [of] investment and you have a fantastic founding team, you may not have a proof point on management, because people may already believe in your team.
But if you had a great idea, and everyone feels as though there’s a lot of maturation required in the business, one of your proof points might be: ‘Hey, we need to build a management team that can take this business to the next level.'”
Investors still expect “healthy growth”
Despite the downturn, Alomar said investors have not lowered expectations when it comes to early-stage growth.
“Right now, you actually need to perform better — more efficiently, more effectively,” he said. “To secure funding right now, you have to be a significantly outperforming business.”
In such a volatile market, many investors are content to stay on the sidelines, which means entrepreneurs looking to raise must demonstrate quality revenue, healthy growth, operational efficiency or some combination of all three.
“It’s actually significantly more difficult to produce the right type of company that’s going to get an active round of investment right now,” said Alomar.
Why founders need to secure 24+ months of runway
In a TechCrunch+ guest post, Alomar wrote that entrepreneurs should secure at least two years of runway, so I asked how he settled on that interval and whether he’ll revisit that if this downturn persists.
“Traditionally, we say, ‘Hey, you need 12 months, and then you can go back to market.’ So that’s kind of the baseline of where we start,” he said. “Then we think about how much time it takes to raise money. Six to 12 months ago, if you’re a good company, you’re raising money within three months [because] there was a very quick process. Today, that looks more like six to nine months.”
At this point, there’s no way to know whether the market has found its bottom, which is why so many investors are amassing dry powder.
“Once the market settles — even if it’s settling at a low point and then slowly begins to rebuild again — it may formally still be in a recession,” said Alomar. “But investors will now have a new baseline for valuation and will begin to invest more actively.”
Today’s volatility will not persist for two straight years, but by that stage, enough dust will have settled to reveal a clearer picture of the new landscape, he added. “And that’s where the market will open up and you’ll be able to start securing investment again.”
How to talk to your investors about pivoting
By now, many early-stage entrepreneurs have realized that they are no longer operating in the same market in which they launched. A pivot is their next step, but before floating that idea with investors, Alomar says founders must get buy-in from their leadership team.
“You can’t just make the decision over a weekend at home, and then come in to work on Monday and tell everybody that [they’re] running a different business,” he said. After soliciting feedback and support from your core team, it’s time to share your rationale with investors, but only if you have a detailed strategy — and a budget — that will make your pivot successful.
To pivot successfully, founders may need to rebuild revenue, ramp up hiring, rebrand or take on multiple initiatives at the same time. But recognize that making a significant shift in focus will also require raising additional capital.
In most cases, investors are aware that a startup needs to change its angle of attack before a founder even broaches the subject, Alomar said. “The board will feel that the business is having problems, and the introduction of a potential pivot — if it’s smart and strategic — is sometimes welcomed.”
Even so, it’s a one-shot deal. “If you pivot too much, you’re basically circling the drain. It’s not something you can do multiple times in a business and survive,” he said.
When it’s OK to leave money on the table
It sounds counterintuitive, but Alomar said early-stage startups should turn down revenue from potential customers that do not support their core business. It’s tempting to believe that a million-dollar contract could put a company on a new trajectory, but if a business with a $5 million run rate takes in $2 million of non-repeatable, non-scaleable revenue, “we look at that as a $3 million business,” said Alomar.
Unique contracts and one-off arrangements will not help founders execute proof points, because they’re not expandable business components. A Fortune 500 client who sounds good on paper might require so much service and support that they eventually become a distraction and resource hog. Investors like revenue, but they’re much more interested in scale, Alomar said.
“The idea is to take the components of your business that are scalable and prove that they work. If those work, you don’t need as much revenue; you just need to prove the formula to build a big company, and then investors are much more likely to invest and participate.”
What to do differently to fundraise effectively during a downturn
In the last few months, I’ve heard more than one VC say that they are looking for reasons not to invest, a notion Alomar confirmed. Later-stage and follow-on investments are increasing, which means entrepreneurs need to rethink how funding rounds come together during a correction.
“They want to kind of hold back, wait and see somebody else take the lead,” he said, adding that potential backers may simply be too skittish to write a term sheet. “You need to engage your existing investors to secure conviction in the business to secure inside capital.”
To give themselves more options, founders should look for outside lead investors and consider doing multiple closes if they don’t need a full round immediately.
“To get to an efficient close … I need to demonstrate conviction to my existing investors, and they need to make sure that I get these outside investors over the hump and ready to write the check,” said Alomar.
“No matter how good your metrics are, no matter how good you look, you’re going to need that kind of conviction and support from your insiders in order to ensure that you’re in a position to secure outside capital.”