Lonne Jaffe
The momentum of the most active 12 months ever for venture investing did not carry over well into 2022, to say the least. As interest rates and inflation spiked, geopolitical challenges arose and the economy began trending downward, fundraising slowed dramatically throughout the year.
But if 2022 was a year of paradigm-shifting dynamics, 2023 will be a year when we’ll determine the winners and the losers — and more importantly, when crisper methods for evaluating success will emerge.
The landscape for software companies
The tech ecosystem has seen a few downturns (though none were meaningful) since cloud computing emerged as a dominant trend over a decade ago, but inflation is a new beast for many of us.
It’s been 30 years since inflation was a tangible, real-world macroeconomic consideration. When inflation is at 7%, if you aren’t growing by at least that much, you are shrinking.
In tandem with inflation, the demand curve is being whipsawed — we first saw a period of strong product growth driven by the COVID-19 pandemic, and now we’re seeing budgets and spending being tightened as startups and mature companies alike prepare to weather the storm.
We’re entering 2023 with a great number of known issues and a constrained ability to forecast what’s ahead. One thing’s for certain, though: This year will be more about nailing it than scaling it.
The predictors of success
In this environment, investors will look for efficiency metrics like high gross margins, strong gross retention rates (how many customers continue to subscribe each year), rapid expansion within customers, decreasing customer acquisition costs, shorter sales cycles and productive sales reps.
Gross retention, in particular, will be critical, because companies must be able to retain customers to stabilize their 2023 growth plans. In a difficult budget environment, high gross retention rates can be a strong signal that customers love your products and get real value from them.
Investors are also watching the path to break-even based on the current balance sheet — via metrics such as cash burn as a multiple of net new annual recurring revenue.
Assuming you have high gross retention rates, it may make sense to burn cash, but it won’t if you are burning more capital than the amount of new business accrued. As growth rates decline, many companies are slashing burn rates accordingly, resulting in a wave of layoffs even at companies with strong balance sheets and market positions.
Customer net promoter score (NPS) has always been important for success, and it’s even more so in this environment. NPS flows through all the relevant financial metrics in a business. The more customer value you generate, the better your logo growth, pricing power, retention and efficiency.
In 2023, companies will have to reevaluate budgets every quarter or even more frequently. A timeline of a few years makes sense for forecasting when the markets are well behaved, but these are not well-behaved times. Today, a year feels like an eternity and as such, companies will need to reevaluate plans more often.
Consolidation in 2023
For companies that need a continuous influx of capital to grow, declining valuation multiples can result in a game of chicken with investors. Startups might try to grow into their previous fundraise’s valuation to avoid a down round while investors wait for founders’ valuation expectations to fall and match the more liquid public markets. At some point, balance sheets will start drying up.
We may therefore see more private tech deal-making in 2023. Depleting balance sheets and lower multiples for fundraising can make exiting via a sale of the company relatively more attractive for some startups.
Some startups may also consider merger opportunities. When strong companies join forces, they can increase efficiencies of scale, deepen customer value propositions and pool balance sheets. While it can be tricky to come up with a fair relative equity valuation, equity-only mergers provide an efficient way to conserve cash.
Equity-only mergers can also alleviate problems with retaining and incentivizing key talent after the merger, which companies typically have to manage via cash-based M&A deals.
Innovation during a downturn
There is an opportunity for automation tech to alleviate inflationary pressure by increasing efficiencies and making everyone more productive. Similar to how collaboration software helped the economy cope with isolation during the COVID-19 pandemic, software-powered efficiency improvement could become the unsung hero of this crisis period by helping to soften the impact of the downturn.
Areas of tangible innovation, especially those that help improve efficiency, will find it relatively easy to raise capital. This is seen today in the hundreds of millions of dollars being raised by generative artificial intelligence (AI) startups.
But it’s often hard to predict the winners and losers as a result of innovation. For example, it was widely assumed that manual labor and simpler knowledge work would be the first activities impacted by AI and automation.
However, with large generative AI foundation models like ChatGPT, Github Copilot and Stable Diffusion, we’re seeing AI systems make enormous progress with highly creative tasks like design, programming, music and writing. This will likely continue in 2023 with the release of systems similar to GPT-4.
With technologies like generative AI, it is difficult to see clearly where the pools of value will accrue and where economic moats will be the deepest.
Some believe that economic power will accumulate at the companies building large foundation models because they require so much time, skill and infrastructure to create. Others feel moats will be deepest at the companies fine-tuning the models for specific use cases because they will enjoy demand-side economies of scale thanks to feedback from users and active learning techniques.
There’s also the belief that the value will be in the non-AI software that allows models to integrate with existing systems, benefiting incumbents, which will use AI provided as a service from players like OpenAI. There may even be a layer of value between foundation model-creation and fine-tuning, requiring a new set of infrastructure tools and skills that focus the foundation model for a specific domain.
All that said, even those convinced of generative AI’s power are concerned that it will be difficult to commercialize or to create sustainable businesses around it, especially given challenges with reliability, intellectual property ownership and privacy.
The case for long-term optimism
We’ll see many innovative products and solutions emerging from this difficult period, similar to previous downturns, which saw the formation and scaling of companies like Microsoft, Amazon and Google.
Even though many people have been affected by layoffs, plenty of roles need filling. For efficient, fast-growing and well-capitalized companies, hiring will likely continue to get easier in 2023. Many talented, entrepreneurial people will also have more time on their hands to build something new.
Bob Iger once said, “The riskiest thing we can do is just maintain the status quo.” Looking at the next decade, the innovators to emerge the strongest will be those who best adapt to this rapidly changing environment.
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