While VCs still have plenty of dry powder, only the best startups are getting backing. Investment in European startups dipped 27% in 2022 and the number of rounds fell 35% on year — indicative of the wider slowdown across Europe’s tech ecosystem.
The year also saw the unicorn flurry slow down — only 47 companies crossed the $1bn valuation threshold for the first time in 2022, versus 69 the year before. The number of investors involved in a financing event for at least one unicorn also dropped, from 650 in 2021 to 425 in 2022.
Given the challenging market conditions, what are the top qualities that investors look for in startups to back? We spoke to a founder, an investor and an early-stage startup growth partner to find out.
1/ A sticky product
Glen Waters, head of the EMEA early stage practice team at Silicon Valley Bank UK, says that the key during a downturn is to focus on your customers and prioritise the fundamentals of your product.
Samantha Rosenberg, cofounder of Belong, a startup aiming to bridge the millennial wealth gap and preparing to launch in 2023, agrees. She adds that the slowdown could be an opportunity to “be more introverted as a business and really get close to your customer, building propositions and products that are truly value adds”.
Research shows that customers generate increasing profits each year they stay with a company. For example, increasing customer retention rates by 5% could increase profits by more than 25% in financial services.
“Companies aren't going to have as much money to spend on social media and digital marketing,” says Rosenberg. “So this could be a time to build a really strong community around your brand through tried-and-tested marketing channels like word of mouth referrals which are also more conducive to customer acquisition costs.”
Maria Wagner, partner at UK and US-based VC Beringea, says that having a steady stream of revenue is most important. “It’s all about long-term propositions with inherent stickiness — the ability to retain your customers' preferences based on some sort of value in your product,” she says.
Waters adds that it is also important for founders to focus on their own wellbeing in difficult times. “Another thing to think about more are signs of burnout — founders need to take care of themselves physically, mentally and emotionally, because you can easily lose motivation if you’re constantly worrying about the situation,” he says.
2/ A low cash burn
Recessions see the death of many companies that have little to no revenue, but like in the dotcom bust of the early 2000s, the surviving ones often go on to become massive wealth creators for investors.
“It comes back to the old saying, cash is king — companies generating losses that are the size of their revenues will be over,” says Waters.
For Rosenberg, a vital necessity in surviving the downturn is ensuring a low cash burn. She adds the Rule of 40 — where a software company's combined growth rate and profit margin should exceed 40% for growth to be sustainable — is “more important now than ever”.
Wagner agrees, adding that it’s essential for founders to know how much their startups need to raise to survive the next 12-18 months.
“Investors want to make sure that we're not going to run out of cash in the next 12 months if they were to do a raise,” she says. “It's very important to think through the business plan, and make sure that founders have enough buffer, so that if things do get worse, they can get through the next 24 months, at least.”
Waters adds that it’s also about working out what kind of startup you are, and for some business models, bootstrapping could work well to start with. “Less than 1% of companies actually get VC funding — so bootstrapping is not a bad thing for the right type of business,” he says.
Wagner points out that a lot more bootstrapped companies came out of the last recession strong as “their economics are a lot stronger, and they can raise VC funding afterwards”. She adds that it could serve as a buffer as fundraising is taking longer in the current market and founders must be prepared for a longer wait.
3/ A strong team and clearly defined mission
Rosenberg says that the downturn is a good time for founders to perfect the narrative around their product and hire the right talent to build on it.
“Startups should invest in retaining and attracting good talent — the force multipliers and the nodes of your culture — so that once the downturn dissipates, you can start rebuilding your business around really strong people,” she says.
For Wagner, having strategic CFOs to function as “thought partners” to the CEO and help them think through different scenarios and analyse the business is important. “We're seeing data science functions, for instance, within finance teams, to dig into and analyse data and draw conclusions,” she says.
Rosenberg says that investors are spending more time now doing due diligence so companies should practise pitches and spend time really crafting the narrative in a way that “does justice to your story”.
She points out that on the flip side, limited resources also means founders should be more mindful of investor propositions and selective of who gets a say in business matters.
“Try to identify those people who get your business and back it even if things get worse, who are going to be really willing and able to stand behind you because they believe in the long-term vision of your business. It usually just takes one believer to get the ball rolling,” she says.
4/ A resilient sector
Fintech outperformed other sectors in 2022, with 14 new unicorns — almost a third of the total. Enterprise software came second with six new unicorns, while security and energy were tied for third place with four new unicorns each.
Interest in healthtech, meanwhile, has cooled following the pandemic boom, and VCs’ best-loved sectors in 2022 followed a familiar pattern. Topping VC funding were fintech, healthtech and business software.
Waters points out that it is important for new startups to pick a resilient sector and for others to pivot their business models accordingly. He adds that there has been a shift from companies that are “nice to have” to the “must haves”.
“More resilient sectors with the right business models in subsectors and verticals such as SaaS, where technology is transforming industries, are succeeding — so these are the sectors which are the most attractive,” he says. “Unsurprisingly, direct-to-consumer (DTC) is taking the biggest hit due to discretionary spending. Having said that, spending is typically higher in DTC, and we'll see some of the most successful DTC companies coming out of the recession, like Airbnb in the last recession.”
For startups that already function in less resilient sectors, Wagner says slight pivots could be highly useful. “Small pivots could be something like looking at pricing — how you price and how you can add functionalities that can help customers get more comfortable with paying that price,” she says.
“And then there's kind of larger pivots — for example, shifting from SME customers to enterprise customers, which generally is a more resilient market, or shifting product functionality to deliver a more mass product, especially in a recession. So it’s about learning how to position the product to fit in this new, cash-constrained environment,” she adds.