Early-Stage Startups Pump Brakes on Growth as Downturn Looms

Growth at All Costs Is So 2021 - Now It's All About Taking a Path to Profitability
Early-Stage Startups Pump Brakes on Growth as Downturn Looms

Nascent startups are ditching the growth-at-all-costs mantra in favor of a novel idea: profitability. Businesses want cash on hand, especially ahead of the macroeconomic storm expected later this year.

See Also: How McDonald’s Keeps Security Awareness Fresh and Relevant

Gone are the days of security vendors at the Series A or Series B phase promising to double sales each year while burning cash on marketing programs even faster than they're bringing in new business. Now, early-stage startups are pursuing more prudent 50% to 70% annual growth rates while conserving cash and taking a path to profitability, venture capitalists tell Information Security Media Group (see: Late-Stage Startups Feel the Squeeze on Funding, Valuations).

"Everyone needs to be cautious in this market to make sure it's responsible growth rather than growth at all costs," Thomvest Ventures Venture Partner Umesh Padval tells ISMG.

A Tale of Two Quarters

Investors during the first quarter continued to ride the high of the 2021 funding boom. Reality set in during the second quarter as inflation, rising interest rates and worries over a potential recession forced early-stage investors to adjust their approach.

Typically, the reality of an economic downturn sets in for early-stage companies within six to nine months of worsening conditions. This time it’s much faster, Rama Sekhar, partner at Norwest Venture Partners, tells ISMG.

"Everyone's gotten the memo that the financing markets are tight," he says. Trickle-down from public market turbulence "is absolutely here now."

In 2021, longtime startup investors found themselves competing with an influx of "tourist VCs" who had excelled at public market investing and thought they could get a jump on the next IPO by taking a position in companies raising their Series A funding, Sekhar says. The desire to box out rivals meant startups were getting $1 billion valuations despite having under $4 million in annual recurring revenue.

Cybersecurity startups received just $3.9 billion of venture funding in the second quarter of 2022, the first time that figure has fallen below $4 billion since the fourth quarter of 2020, according to data from Crunchbase. Deal flow also slowed, with only 170 cybersecurity funding transactions announced in the second quarter - the smallest number seen since the third quarter of 2021.

The slowdown also affected early-stage firms, with five of the eight largest Series A and Series B funding rounds coming in the first quarter of 2022, Momentum Cyber found. A subpar second quarter resulted in Series A deal volume falling to 83 in the first half of 2022, compared to 98 a year earlier. Series B deal volume dropped from 51 to 45 deals over the same period. Eric McAlpine, who founded Momentum Cyber, tells ISMG that VC firms are less likely to take the risks for new deals now.

"Investors are basically telling companies, 'We want to monitor you for another quarter or two,'" McAlpine says. "There's just less FOMO in the market than there was six to 12 months ago."

Johnny-Come-Latelies

The run-up in security funding and valuations in 2021 was driven by newcomers getting caught up by hype, says Alex Doll, Ten Eleven Ventures founder and partner. Their ardor cooled as late-stage startups approached the public market and investment banks didn't assess them with the same valuations or multiples.

"This is a market that a lot of people found attractive during the pandemic and wandered into without a lot of expertise," Doll tells ISMG. "Everyone started pricing everything as if it was the market leader and the next great cybersecurity company. And that just can't be true. You can't have five next-gen VPN companies that are going be market leader. Only one can be the market leader in any given segment."

Liberty Strategic Capital, the private equity firm run by former U.S. Treasury Secretary Steven Mnuchin, went big in its first-ever cybersecurity investment, leading a $275 million Series F funding round for Cybereason in July 2021 on a valuation of $3.3 billion, according to Pitchbook. Eleven months later, Cybereason had to lay off 10% of its employees in response to deteriorating market conditions.

Generalist tech funds have difficulty understanding what types of security technology could gain traction in enterprise accounts and pricing those capabilities accurately, Doll says. Cybersecurity is a unique investment market because it's so technical, Doll says, with companies typically coming to market with a product that addresses a niche issue and eventually broadening it into a platform.

Venture capital firms without cyber expertise are scaling down their bets in the market or attempting to get smarter by bringing onboard as advisers senior personnel from cybersecurity firms, such as the chief executive or CISO, Doll says. He adds that lack of knowledge about technical solutions and the competitive environment often leads to poor pricing.

"A lot of the investors who don't have knowledge of the space don't understand where the innovation and tech is coming from in the early-stage ecosystem," Doll says. "If you don't have a handle on that, it's very easy to misprice investment."

General tech investors may only have two or three people dedicated to the cybersecurity market while dedicated security investors such as Forgepoint Capital have more than 15 people focused on the space, says Managing Director Alberto Yepez. It's nearly impossible for one individual to have domain expertise in everything from fraud to cyber insurance to threat intelligence, he says.

"They were making investments based on financial projections and financial models, not on the core business fundamentals," Yepez tells ISMG.

"Adversity makes you stronger."
– Alex Doll, Ten Eleven Ventures founder and partner

'A Little Bit of Tentative Behavior'

Early-stage startups are feeling the squeeze not only from investors but also from prospects and customers. CISOs are increasingly getting told by their finance departments that they can't buy security technology outside of the budget cycle, no matter how impressive the proof of concept. Yepez says that's making it harder for startups to convert engaged prospects into net new customers.

New initiatives at publicly traded companies are being put on hold until the company stock returns to a certain price level, Yepez says. As a result, many of Forgepoint's portfolio companies found that second-quarter revenue came in roughly 10% short of projections, with a reduction in new net customers, less upsell to existing clients and smaller deals leading to the shortfall.

"We're beginning to see a little bit of tentative behavior around new purchases," Yepez says.

Deals with larger annual contract values are starting to experience longer sales cycles as customers delay pulling the trigger, says Ofer Schreiber, senior partner at YL Ventures.

The slowdown is even crueler to more mature startups. While seed companies are sheltered from the storm, Series A companies are starting to be affected and Series B firms have been significantly affected, McAlpine says. Seed companies are small and agile and don't burn a lot of capital, and investors want to keep founders motivated by having them retain lots of equity, according to Schreiber.

When Series A rolls around, financial backers are investing in the founders, the management team, ideas and early-stage software platform, but they can't actually evaluate revenue since the company doesn't have any yet, McAlpine says. Series B is an entirely different animal, he says, since the company already has 10 or 20 customers and is looking for additional capital to expand its go-to-market capabilities.

"It's at that point where investors can be much more scrutinizing with valuations because if they feel like the whole economy is slowing down, they might not feel like they want to take that go-to-market risk," McAlpine says.

"We're trading off hyper growth for good growth."
– Eric McAlpine, Momentum Cyber founder

'Playing the Waiting Game'

That leaves founders looking to raise a Series B with a terrible choice: Do they raise less now and risk not having enough money to get through the recession? Or do they fill their coffers with cash but dilute their stake in a company they've built from the ground up?

Lytical Ventures Managing Director Steve Berg found that companies of lesser quality are raising smaller rounds while companies of higher quality are hauling in the amount they expected to raise but at a lower-than-expected valuation. This gives venture capitalists the chance to take a position in higher-quality companies that now have valuations more tethered to reality, he says.

Conversely, Doll is telling Ten Eleven's portfolio companies not to dilute themselves in a down economy by raising more money than they absolutely need. Startups should raise the minimum amount needed to hit growth milestones and demonstrate their business model over the next two years, when the market will be more receptive to startups' capital requests.

"A lot of companies are better off playing the waiting game and seeing if the market rebounds and multiples come back. The valuation multiples can't get much worse, particularly for private growth," Doll says. "For some reason, a lot of founders want to raise a big number and make a splash as opposed to really thinking about what they need in their business."

Roughly 80% of Norwest's portfolio companies were able to raise enough money in 2021 to fund operations for at least two years, while the remaining 20% either needed to do so under unfavorable conditions or look for a financial or strategic buyer, Sekhar says (see: PE Firms 'on Prowl' for Take-Private Cybersecurity Deals).

Momentum Cyber encourages Series A companies to extend their cash reserves from 18 months to two years to address economic uncertainty, McAlpine says. Startups typically can ensure another quarter or two of cash without having to completely reengineer their cost structures, according to McAlpine.

"We're trading off hyper growth for good growth to extend the runway out and show a path to profitability," McAlpine says.

None of Momentum's clients have gone through layoffs, McAlpine says, but he encourages any company considering cost reductions to trim go-to-market rather than engineering or research and development. Schreiber thinks the economic downturn will last at least 18 months, and YL Ventures is urging its portfolio companies to be sufficiently capitalized to get through that period of time.

"If you're able to achieve 24 months of runway, you have full control over your destiny," Schreiber says. "You're able to decide the timing that you will go out and raise your next funding round. But if you don't have that, you lose that control. It means that you will be forced to go out and raise capital when you're not in the best position."

'We've Swung the Pendulum Back'

As funding dries up for security startups, investors are more sternly scrutinizing founders. For startups that had a proof of concept and a few initial customer deals in 2020, Yepez now wants to see the product in production environments and the startup expanding to more use cases and customer accounts.

Forgepoint Capital will only back a startup if it sees a clear path to tripling the initial investment, though it typically prefers an anticipated return of five to 10 times the original outlay.

"We invest with the exit in mind," Yepez says.

One financial indicator Norwest prioritizes in its vetting process is burn multiple, which measures how much cash a startup is spending relative to its annual recurring revenue, Sekhar says. Norwest wants prospects to have a burn multiple as close to 1 as possible, meaning the startup spends $10 million to add $10 million of ARR.

"Investors want to see efficient growth now, not just growth at all costs," Sekhar says, "and the burn multiple is an easy way to measure the efficiency of a growth engine."

Momentum Cyber focuses on unit economics of sales, which is measured by taking the total amount of revenue gained from a customer and dividing that by the cost of acquiring the customer, McAlpine says. A customer that costs $200,000 to acquire and subsequently spends $2 million with the startup has a 10x unit economics rate, which is considered a great return on sales acquisition costs.

In light of the economic downturn, unit economics analysis is being done earlier in a startup's journey, with a higher bar for companies to clear, McAlpine says. Startups nowadays are expected to have unit economics of at least 3x to 4x and a clear path to profitability within the next three to five quarters, he adds.

"The better your unit-level economics are, the quicker you can be profitable," McAlpine says. "Investors want to make sure that you're not going to go and burn a lot of money in the process of getting to be profitable. If you look at last year, we were under a growth-only paradigm. Now, we've swung the pendulum back to a more rational, balanced approach of growth and profitability."

"If you look around and everybody else has stopped hiring, maybe this is the right time to be looking for talent."
– Rama Sekhar, partner at Norwest Venture Partners

The downturn provides a competitive edge to well-capitalized startups as well as investors. Emerging vendors looking for engineering talent over the past half-decade have been forced to compete against the likes of Google, Apple, Facebook and Netflix.

Now that many tech giants are in layoff mode or have implemented hiring freezes, security startups that are well-funded and have a good product market fit can afford to hire previously unobtainable engineering talent. In fact, Lytical's Berg recently heard from one of the firm's portfolio companies that Microsoft had let go of many sales engineers. Engineers with young families might not leap to a startup, but risk-takers will see this as a good opportunity to get equity without giving up much on salary.

In this changing job market, high-performing seed and Series A companies now have access to talent previously tied at the hip to tech giants that can offer extremely large pay packages, Berg says.

Deep-pocketed startups have the opportunity to hire from a highly qualified labor pool and to expand into new technology areas, Sekhar says. Harness raised $230 million on a $3.7 billion valuation in April to extend its CI/CD developer toolkit into security, while Productiv raised $45 million March 2021 to help finance and procurement departments shut down SaaS spending.

"This is an opportunity for companies that have cash to pull ahead," Sekhar says. "If you look around and everybody else has stopped hiring, maybe this is the right time to be looking for talent."

Responding to a Bear Market

Many startups that aren't part of the fortunate few are opting to defer new hires and slow spending on marketing, events and trade shows. Companies at the Seed, Series A and Series B phases are typically able to avoid layoffs. Instead, many are cutting headcount expansion plans in half over the next 12 months, says Doll.

Doll urges early-stage startups in a bear market to zero in on their top three to 10 most important customers and forgo initiatives to expand into new geographies, customer areas or technology segments. Breaking into markets such as the U.S. government and Europe requires a large upfront investment to understand the specific dynamics and would likely result in cutbacks if conditions worsen.

Many companies fail to understand their strengths based on initial sales, Doll says. Products developed for large enterprises may not translate well for small to midsized customers.

"If you look across the history of cyber, not a ton of companies that were born at price points where they sell to the CISO made it down-market successfully," Doll says.

Momentum Cyber has found it pays to be maniacally customer-centric during a recession since a startup's first 10 or 20 customers can serve as acolytes and evangelizers for the company and create a robust lead-generation pipeline. This is particularly important in an economic climate where many startups can't afford to hire more salespeople, McAlpine says.

Forgepoint urges its portfolio companies to focus on the product that accounts for the bulk of revenue and stop research and development programs tied to tangential or ancillary offerings. Surviving an economic downturn is a marathon, not a sprint, Yepez says, so targeting revenue growth of 50% rather than 100% provides more cushion by controlling spending.

Thomvest's Padval had a slightly different take, arguing that smaller and midsize companies offer quicker time to revenue in choppy waters since they make purchasing decisions faster than larger counterparts. At the same time, large enterprises are the most effective path to growing ARR over the long run, so startups can't afford to neglect the upmarket to make a quick buck from small clients, Padval says.

"Be cautious but not too cautious," Padval says. "Figure out when speaking to customers if budgets are there and, if so, go for it."

Forming the Startups of Tomorrow

Belt-tightening during a recession extends all the way from startups to publicly traded companies, prompting the latter to cut experimental, innovative projects and revert to their cash cows, Sekhar says. As a result, product and engineering leaders with companies such as Facebook and Google become more open to speaking with venture capitalists about starting a new company.

Norwest has therefore ramped up its "founder dating" program, which brings together product and engineering leaders from different organizations in hopes of starting new companies. Being the matchmaker almost always means Norwest gets to write the first check into the startup, creating more top-of-funnel volume for the venture capital firm, Sekhar says.

Sekhar is most interested in helping to establish companies that can automate security operations centers, build low-code security orchestration automation and response, analyze and investigate threats, and secure the software supply chain.

"The conversations are around, 'Look at this opportunity to create a new company. And here's half a dozen people you might be able to do it with,'" Sekhar says.

And for folks who've already founded a startup, economic setbacks are a great way to learn who's committed to the company's mission. As salespeople experience multiple quarters of low commissions and other workers see limited appreciation in their equity, Doll says it becomes apparent which ones are motivated by mission rather than money.

"Adversity makes you stronger," Doll says. "Great CEOs and good entrepreneurs use adversity to sharpen up their company."


About the Author

Michael Novinson

Michael Novinson

Managing Editor, Business, ISMG

Novinson is responsible for covering the vendor and technology landscape. Prior to joining ISMG, he spent four and a half years covering all the major cybersecurity vendors at CRN, with a focus on their programs and offerings for IT service providers. He was recognized for his breaking news coverage of the August 2019 coordinated ransomware attack against local governments in Texas as well as for his continued reporting around the SolarWinds hack in late 2020 and early 2021.




Our website uses cookies. Cookies enable us to provide the best experience possible and help us understand how visitors use our website. By browsing careersinfosecurity.asia, you agree to our use of cookies.