Everyone knows that over the last several years, VC money has been abundant and relatively cheap. This created an environment where the motto was ‘growth at all costs.’ Seemingly, the recipe for a successful venture backed company became very cookie cutter. Raise capital every 18 months. Invest heavily in go-to-market. Grow revenue at a ‘standard’ rate of tripling in year 1, tripling again in year 2, and then doubling thereafter.
These ‘VCisms’ borne out of an era of plenty have permeated boardrooms and investor meetings everywhere. In fact, the question of ‘how long do you expect the capital raised to last you’ essentially became an intelligence test. The only right answer has been 18 - 24 months without consideration to the specific facts and circumstances of the company.
While people may not be saying it aloud yet, these VCisms are starting to feel outdated. Growth at all costs doesn’t work when capital isn’t readily available or when it is very expensive from a dilution perspective. And, raising capital every 18 months feels very onerous when it no longer takes one month to raise a round but instead takes three to six months or longer.
It’s time to ask ourselves—are these VCisms still relevant or is it time to change? First, let’s take a look back.
How did we get to a growth at all costs mentality?
At this point, everyone knows that the cost of capital declined in recent years. This is mostly discussed through the increased valuations companies were receiving at varying stages as shown below in Chart B.
Across all stages, companies were seeing increased post-money valuations anywhere from ~40% at the earliest stages to >200% in the growth stages during the 2018 - 2022 environment compared to 2012 - 2018.
Said another way, over the last three years, a company could raise the same amount of capital but experience less dilution.
But, what isn’t talked about often is the fact that the data shows us that companies did not, in fact, raise the same amount of capital. They raised more capital at each stage – significantly more capital. As shown below in Chart C, the median Series C was more than double the size over the last several years than from 2012 - 2018.
So, the net result was, on average, slightly less dilution as shown in the Chart D below.
For example, existing equity holders (e.g. Seed and Series A investors, founders) were diluted a median 22% from the subsequent Series B raise during the 2012 - 2018 timeframe versus 20% during the 2018 - 2022 period. That’s only a 10% difference. The more notable difference is that companies received more than twice the capital for this dilution in the different time periods (i.e. $25M versus $11M as noted in Chart C). This capital could be utilized to fuel growth through the hiring of salespeople and marketing efforts.
If dilution was similar, does that mean that the investor return experience was similar?
Let’s take the median valuation of a Series C company over the 2012 - 2018 timeframe of $120M. Assuming an investor received 15% ownership in the Seed round for a ~$1M check and then was diluted each round thereafter, the data indicates that the investor’s ownership after the Series C raise is ~7.2%. Therefore, the investor’s return on paper would be 7.2% X $120M = ~$8.6M. The multiple of return would be ~8x given the initial check size.
Now let’s compare this to the 2018 - 2022 timeframe when the median valuation of a Series C company was $380M. Again, assuming an investor received 15% ownership in the Seed round (this time with a ~$1.3M check based on the data) and is subsequently diluted, the investor’s ownership after the Series C raise is ~7.9%. Therefore, the investor’s return on paper would be 7.9% X $380M = $30.2M. The multiple in this scenario given the initial check size is ~23x. Nearly triple the return from what investors experienced in 2012 - 2018.
To be clear, the founders and company employees benefited as well from this enhanced valuation environment, which is why the cycle of raising large rounds of capital frequently began to become the norm.
Does ‘growth at all costs work’ when costs are rising?
Let’s look at the historical data below in Chart E to inform us. If a company were to raise the same amount at each stage as was the median during the 2018 - 2022 period but do it in the valuation environment from 2012 - 2018, the dilution experienced by the founders would be significantly higher.
Said another way, if capital is more expensive, then either you must raise less capital or experience significantly more dilution. The data shows that, instead of experiencing ~20% at the Series B stage as just noted, equity holders would experience 53% dilution for the same amount of capital raised.
The short answer, therefore, is no. If our current environment is more similar to 2012 - 2018 than the last three years, ‘growth at all costs’ will get a makeover to ‘growth at reasonable costs.’ Founders will not want to experience this level of dilution, and investors won’t either.
To put it in more specific relief, if we use our same assumption that an investor acquires 15% ownership in this company at the seed stage, after accounting for the subsequent dilution through the Series C, ownership will decrease to a measly 2.6% compared to the 7%+ ownership in the prior examples. Owning 2.6% versus 7.2% of a $380M company translates to ~$10M of value versus nearly $30M of value respectively.
Is planning for slower growth allowed?
As capital becomes more expensive, companies will face two options – 1) continue to raise sizable rounds as in recent years but experience much more dilution or 2) raise less capital and grow at a more modest pace. As we just learned, the potential increase in dilution may not be tolerable to investors or founders, so the answer is yes – though it’s going to be an adjustment for investors, founders, and employees alike.
If a company decides it wants to continue raising meaningful amounts of capital, as in our example above, in order to achieve the revenue growth targets or tripling, tripling, and then doubling, we now have an estimate of ownership percentage of ~2.7%.
As shown in Chart F, assuming it follows the same trend as companies in the 2018 - 2022 environment, revenue at the Series C will be $30M. Using the median valuation multiple from the 2012 - 2018 environment of 10x, we can assume a company valuation of $300M and value to the investor or 2.7% x $300M = $8.1M.
If instead the company decides to raise less capital and follow the median revenue trajectory from the 2012 - 2018 environment, we can assume a revenue of $12.2M. Using the same revenue multiple of 10x, we have a company valuation of $122M. Given that the company grew without raising as much capital, we have an ownership of ~7.2%, which implies the value to the investor of $8.8M.
While it may feel counterintuitive given the recent market environment, the value of the equity for all parties – investors, founders, employees – in this scenario is higher in the more conservative growth scenario.
Utilizing history as our guide, it is possible for equity owners to generate more value with more conservative growth – assuming they are able to reduce the impact of dilution. Therefore, this is a scenario all companies must consider in setting future budgets.
Are there more specific examples of how founders can use this information for budgeting?
Let’s use an example to help bring this information into use. In this case, we have an enterprise software company that closed its Seed round in June 2022. There is a high probability that their current financial plan has them running out of capital between December 2023 (i.e. 18 months) and June 2024 (i.e. 24 months). Why? Because, as noted, that’s the rule of thumb we’ve all lived under for the last several years.
Now, this company is looking to re-forecast its budget given the change in the environment. Let’s assume the company has runway through March 2024 – the midpoint of our range. As we noted earlier, financial raises are taking longer on average, and, if a company is low on liquidity, investors can be punitive with valuation. Therefore, the company wants to formally launch a raise with at least nine months of liquidity remaining. This implies starting the fundraise in June 2023.
One thing to note is that, commonly, enterprise software companies do the majority of their sales in the fourth quarter when their potential customers have money to either spend or lose once the new year comes.
Let’s assume our company is still in ‘growth at all costs’ mode and wants to triple revenue in the year and is spending more aggressively to achieve this.
As shown above in Chart G, based on this plan, our company is likely raising off of ~$6.25M of revenue which is the 2Q 2023 number. Continuing to utilize our 10x revenue multiple, this implies a valuation of $62.5M.
Consider instead if the company decides to limit sales and marketing expenses to extend runway to take advantage of 4Q growth as seen below in Chart H.
In this case, while total 2023 growth will be lower, the company could be raising capital off of 4Q 2023 numbers instead. This implies a valuation of $100M, or a 60% increase in valuation for its financing. By extending runway and waiting to launch until after they close the books on the fourth quarter, they can potentially meaningfully impact their next round valuation.
The net result in this scenario is that the company may want to budget for a 27 month runway. Currently, 27 months still feels uncomfortable to say out loud (or type), but it may be the best path for this company.
Of course, there are many caveats. Investors may give companies credit for their future revenue targets, in which case, more aggressive targets can lift valuations. That being said, companies should expect investors to be very skeptical about go-forward plans in this new environment.
At a minimum, both investors and founders should open the door for a discussion without preconceived notions.
In environments with more volatility, canned responses or advice don’t really hit the mark. The sooner we begin to have company-specific conversations and acknowledge that the cookie cutter recipe for success isn’t sufficient – the better for all parties involved.
Revisit the VCisms you are holding as truth. Determine if they are still applicable for your specific company given your cash runway, sales efficiency metrics, VC relationships (e.g. their ability to bridge you), etc. Run varying scenarios for your financial plan, and do not be afraid to make changes. Consider ‘growth at reasonable costs’ – where you, in conjunction with your board, get to determine the definition of reasonable.
VCisms will likely never die – but it is time for a new era.
A version of this article originally appeared on TechCrunch