How to evaluate startup offers in a downturn
It feels like a precarious time to join a tech startup. In the last few months, public market valuations of companies have come way down. The Bessemer cloud index, which tracks average public SaaS company prices, shows that the total market cap of SaaS companies has been cut by more than half in the last few months. This has been going on for a few months, but in the last few weeks, reality seems to have hit startups all at once–the funding market has basically dried up and many startups have announced layoffs or shutdown completely.
To be clear: I still think it’s a great time to join a startup right now (after all, I’m writing this from my early stage startup’s blog). But if you're considering joining a startup, here are a few things to consider when doing your diligence before joining. They're probably questions you should have been asking anyways even during the good times, but have outsized importance now.
How much actual runway does the company have left?
Asking about runway is already a common question, but I find that the answers companies can give can be a bit misleading or over-optimistic. For example, someone may project 2 years of runway, but that may be based on revenue growth or margin improvement forecasts that may or may not materialize.
Instead, I'd ask the following:
- How much money is currently in the bank?
- How much money is the company burning each month on average, net of revenue? I.e. by how much is the bank balance going down each month?
This gives you a very clear picture of their likely runway. If the company spent $1M on average each of the last 3 months, and has a total of $15M in their bank account, then they probably have around 15 months of runway. Of course, they may have a really solid plan to reduce that burn in the next 6 months, and on the flipside, they could start to burn even more money if they hire a lot or have customer churn. But overall this approach allows you to get a realistic view of burn without having to take a plan on faith.
This is always a good thing to ask, but it's especially important during a downturn. A company might a have a really smart, solid plan to reduce burn by growing sales, for example. But those sales growth assumptions, even if based on really solid historical data, may not materialize–during a downturn, companies shrink budgets and cut spend. The startup may find it harder than expected to actually drive sales in the next year.
Don't assume bigger companies are inherently safer
A few months ago, a friend of mine gave a job offer to someone to join in a leadership role at her 50-person startup. This person also had an offer to join a payments startup with 500+ people at the time. My friend's startup had raised a small amount of money but had been mostly profitable since early. By contrast, the other startup had raised over $120M in funding. The candidate chose to join the larger startup because they perceived the bigger, better funded company to be a safer and more stable job. A few months later, the larger startup was bankrupt, while my friend's company had continued to grow profitably to 60+ people.
Getting an honest view of runway, as mentioned above, is a great way to avoid a scenario like this one. The candidate in question could have asked two simple questions to learn that the company they joined was burning $10M/month while having $40M in the bank.
This story might sound like it was literally made up for this blog post, but it's unfortunately true. I've also seen tons of other less extreme versions of this play out a lot over the last few months, with people choosing to join heavily funded companies that are a lot shakier than they look from the outside.
There is no size of company that’s insulated from layoffs or downturns. Even huge public companies like Netflix have recently gone through layoffs, and companies like Facebook have announced hiring freezes. Instead, look for companies that have evidence that they’re a bit insulated from current conditions: are they cashflow positive (or very low burn/long runway) and continuing to meet growth targets? Or did they just raise a huge funding round with no need to raise again for a very long time?
Don't trust optimism about the "next funding round"
In the case of the bankrupt payments startup above, the reason they felt OK burning money so quickly was because they assumed that the next funding round was bound to happen. A lot of founders, especially ones who had an easy time raising their last couple rounds, project a lot of confidence that the next round is "definitely" going to happen at a "conservative" valuation of $X.
People will say things like, "we raised our last round at a $100M valuation, and we've tripled revenue since then, so we'd likely raise at $300M today." This is not automatically true. Plenty of high-quality, fast growing public companies like Datadog and Snowflake grew really quickly over the last 12 months while their stock price dropped a ton. In fact, multiples are down so much that a company that grew 2-3x in revenue might even be unable to get the same valuation as last time, especially if growth is slowing.
Even in the best of times, saying that the next funding round is guaranteed is sloppy rhetoric. Founders aren't necessarily lying–a lot of people really do believe it will happen, and their current investors may also be reassuring them that the round will definitely happen. But unless there's a signed term sheet, assume a round won't happen until it actually does. (And even signed term sheets can fall through). A lot of founders still haven't fully adjusted to the reality that the 2021 funding environment is over.
Option strike price can wipe out your equity value
Most startups grant equity in the form of stock options. Typically, these stock options are presented to you as being "worth" the price per share at the most recent funding round. E.g. investors might have paid $10/share to invest most recently (i.e. the preferred price). And you can purchase these options at a strike price which is typically somewhere between 20% and 50% of this price. You can read more about how startup equity works here.
Many people ignore the strike price when thinking about the value of their options, but it's important to consider, and it's especially important in the current environment. I'll walk through why below.
Let's say you've been given an offer to join a late-stage SaaS startup that was valued at $10 billion in their last funding round, which happened in 2021. Your options are worth $300,000, and the strike price is 1/3 of that number, so it costs $100,000 to exercise them. If the company got sold tomorrow for $10B, you would make $200k in profit (before tax).
However, the 2021 funding market was absolutely wild. Tons of companies raised at enormous valuations based on revenue and growth that was strong, but nowhere near where you'd historically expect for those valuations. The Bessemmer cloud index shows that in the public markets, an average SaaS company is worth about 40% of what it was at peak last year. Which means if your prospective $10B startup went for an IPO or acquisition today, you might expect it to actually be worth $4B, but because it isn't public, that's not immediately obvious.
So this means your options would actually be worth 40% as much, right? Wrong. The "realistic" value of your $300,000 option grant might now actually be worth $120,000. But you still need to pay $100,000 to exercise your options, which means you'd only net a $20k profit, or 1/10 of what it was before. There are scenarios where the realistic value of your options might even be negative.
Overall, this might still be a good opportunity and a great company! You should just go in with a realistic view of the value of the equity and not just assume the most recent valuation is "correct."
Note that this preferred/strike price crunch is going to be most acutely felt at late-stage companies. For early stage startups, the strike price tends to be really low as a ratio of the preferred price. Even if the company is overvalued, the strike price is usually so low that the market value for the company still is well above that number. However, this isn't a hard-and-fast rule so you should still ask about these numbers and do your own math.
Don't assume anything is "recession-proof"
Some companies claim that their products are recession-proof and will do fine, or even thrive, in a downturn. This might be true, but the set of companies for which this is actually true is likely much, much smaller than the number of people I've heard anecdotally claim about their own company.
In a recession, most people and businesses spend less money. Whatever you're selling them, they have less money for it. If you're claiming that your product's sales will be unaffected by a recession, then you're claiming that people or businesses on average will spend a higher percentage of their remaining budget on your product, not the same.
An exception might be if you're selling something that is more necessary in a downturn. For example, if your company is the low-cost vendor in a space, people might start switching to you over a competitor. In general though, most explanations I've heard for why a particular business is recession-proof are pretty thin, and you should be somewhat skeptical.
If you want to stress-test this a bit, you can ask a company how their Q1 and early Q2 results have gone vs their plan. The current downturn didn’t happen all at once–companies have been preparing for this for a few months now–and if a company is continuing to meet their goals, it might be (mild) evidence that they have a strong product offering that will do alright in a downturn. But if they’ve started to miss plan by even a little bit, it could quickly balloon into huge misses soon.
How have their plans changed?
One final thing to ask is whether the company is doing anything differently due to the current market conditions. If they had an aggressive hiring plan, and they’re continuing to plow full steam ahead, it could be evidence that the company hasn’t adjusted to the new environment and is weeks or months away from having a really unpleasant realization along with layoffs.
I should note that a company’s plans don’t have to change–it’s possible the existing plan was already well adapted to the new environment. For a trivial example, if you’re considering joining as employee #1 at a seed stage startup, and their plan was, “we’ll hire a couple engineers and build product for the next couple years,” there’s not much there to really change.
Overall, the above should hopefully give you a high-level framework for pitfalls to look out for when joining a startup. But as I mentioned at the outset, don't take away from this the idea that you shouldn't join a startup at all. If anything, this is an excellent time to join a startup. The companies that will thrive long-term are those creating really valuable products and sustainable business models. In the last couple years, a lot of really dubious companies raised lots of money, and many of them won’t survive. But if you do your diligence and join a high-quality company, the odds are much higher that the company’s success will be real, enduring success.
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