Startups: Seed & Series A in a downturn market

We took some time to monitor market sentiment, interview our VC partners and review our own investment thesis. By reading this material, you will understand how we approach startup screenings and investing in Seed & Series A. In 2022, YC suggested their startups cut costs and extend the runway by fundraising bridge rounds.

”During economic downturns VC funds slow down their deployment of capital. This causes less competition between funds for deals which results in lower valuations, lower round sizes, and many fewer deals completed. In these situations, investors also reserve more capital to backstop their best performing companies, which further reduces the number of new financings.”

What does it mean for angels?

Potentially good deals for those who will remain investing. Let’s dive deeper.

VC partners who are raising funds are getting into a difficult situation since their LPs (pension funds, family offices) most probably will readjust their portfolio - stick to cash, commodities, energy/value/healthcare stocks which usually cope better with rising rates or simply will take advantage of the recent tech rally and rebalance their tech portfolios to increase exposure to quality tech companies.

Volatility is likely to remain elevated due to macroeconomic uncertainties. Market turbulence this year has rocked tech investment heavyweights like Japanese titan SoftBank, which has written down the value of its private investments and reported a $26.2bn loss in its flagship Vision Fund as tech stocks plunge amid soaring inflation and market volatility sparked by war in Ukraine and anti-covid lockdowns in China.

Valuation inflation at the growth/pre-IPO stage grew at unsustainable levels despite these companies typically growing at a much slower rate than earlier stage tech companies.

We can assume that hedge funds will retract from investing in startups based on the facts. The deal volume will come from 10 to 1 for them. Mature VC funds will continue investing, and other partners without too much success will struggle to fundraise their following funds - this market condition brings more opportunities for deal-by-deal angel communities.

Our principles

We will look into round A-stages & business model predictability: verified product-market-fit, focus on customers and revenue, high margin, predictable cash flows, balanced burn multiple and CAC payback.

It’s not a founder-friendly environment anymore. Funds will try to get 50%+ lower valuation. We will bring fundamental expertise not screwing up founders, but we will ask for 1x liquidation preference, preferred stock (with a condition to convert to common stock in two years) or/and pro-rata rights.

Scoring model

Below you can see some insight into where do we put emphasis while screening the teams and their founders:

• Burn Multiple Efficiency - We aim to find teams close to self-sustainability or have a clear plan of how they can turn the ship around towards it quickly. (Ideally - x0 - x1,5, all below needs to be examined towards plan B)
• Valuation - We would like to understand how the team came up with the number even more. If we would like to acquire the company now, what would be the number founder would be okay to sell and why. We want to learn more about the logic, mindset, and if the founder understands the whole picture within the discussion. Is he taking into account current investors, showing a win-win mindset. With no clear explanation, we are in a position to negotiate a lower valuation. Exit strategy plans?
• Market size: Minimum 1bn + € with the growing trend.
• Growth - If the team is within the brackets set in the Burn Multiple Efficiency, we would be looking for a 10-15% growth MOM minimum. Suppose the team can grow even faster but still meet Burn Multiple Efficiency metric - excellent! Teams with less than 10-15% growth MOM will be mostly excluded as we need to see the possibility of growing our investment ROI.
• Price structure formation - We will be exploring the industry standard within the teams` niche and how they came up with the price of their product, what it contains, and how it was calculated. Also, see the spending culture of the team.
• CAC payback period - How long does it take to get back the amount of CAC. We would be looking to see if the founder knows the industry standard within their niche. Also interested in CAC generally, how was it calculated, and was the sales-cycle / onboarding period considered?
• Revenue - Not a hard number, but to set the tone, we would be aiming for the teams with 7000+€ MRR. In the case of the non-SaaS team, we will check the last periods to understand how stable is the Revenue.
• Runway - We would like to see the team having at least 6 months of the runway by the time we start the process with them. Too often do we see “last minute” approaches. Now, suggesting that fundraising will become more complex, we need to see stability.
• Marketing - We would like to understand more what is the turn rate? How many clients have turned within the past 6 months? How many new ones were added, and what is the ratio % of customers versus paying customers? If we see that this ratio is lower than 30%, we would like to hear a clear plan on how it can be raised and why is it so for now. Otherwise, this is not the team we would take into a process.
• Sales Cycle and Onboarding cycle - Interesting to learn the average wallet size of the customer? What is the sales and onboarding cycle period?
• Team structure - Soft criteria, but as there will be more and more professionals on the market as companies will have to look at the layoffs (example of Klarna), we would like to see if the founder is seeing this opportunity? We would also like to understand the setup of the knowledge base within the company and see how ready are they for remote team possibility. We see more value in international teams due to more talent being available worldwide.
• Cap Table - We would like to see founders holding the significant majority of shares + we would like to see earlier investors joining the next rounds. If this is not the case, we would like to understand why? We would also be interested in how active and helpful are investors who joined earlier. As we are hands-on, we would like to see the same culture.
• Clients - We must understand the profile of the customers; this helps us understand whether the team has found a product-market fit or not. If the segments are from cleaners to bankers to big corps, we will look deeper to understand why it is so.
• Finally, we will also be looking to add, where possible:

1. 1x liquidation preference - Securing our investment made for our members.
2. Preferred stock with a condition to convert to common stock within the next 2 years - limiting the early risk while being more flexible later when trust is gained.
3. Pro-rata rights  We would like to make sure we are not diluted for an upcoming round and later ones (if possible).