What you need to know:

• Venture capital poured into start-ups at record levels in 2021, fuelling an ad boom. “Funded start-ups were the new FMCG,” per Hardhat’s Dan Monheit. "I can’t think of a period where we had so many new brands across so many categories all hitting the market at the same time – ecom, buy now pay later, meal delivery, media – it was everywhere."
• Now the market is correcting. VCs are “pulling in their horns”, capital is more expensive and exposed start-ups are cutting spending and staff. Some agencies are balancing portfolios away from start-up brand work toward CX-type work for more mature businesses – telco, utilities, banks.
• VCs still have money to invest, but the terms are tougher. They want to see profit and recurring revenue.
• But unreliable digital metrics are making it harder to gauge true customer acquisition and lifetime value costs, per growth consultant John James: “The feedback loop is broken”. With due diligence sharpening, James thinks firms that nail attribution will hit pay dirt. In the meantime, for those with cash, he sees a swing back to mass brand channels.
• Shadowboxer’s Stephen Graham sees more pain incoming. “But for those actively looking to invest, it’s a great time to be in market, because valuations are more realistic. VCs still have money to invest in the right founders that are cracking a problem. So we see the next couple of years as an opportunity to build those businesses.”
• Investment banker turned tech PR Jen Harrison said proptech is still “going gangbusters” because it is solving genuine problems, whereas some arbitrage-based business models within fintech “were just gouging a margin”.
• KPMG’s Amanda Price thinks the contraction will be “short and sharp”, but said reports of a VC-start-up death spiral are greatly exaggerated. 
• “There is a lot of dry powder that will need to be deployed … and the Australian start-up market is pretty strong,” said Price. Meanwhile healthtech, deeptech and climatetech are booming.
• While some firms have shifted into cash preservation mode, "differentiation through brand will still be hugely important. If it was me, and I had the cash, I'd use this opportunity to win."

Across the piste, “we’re seeing tightening,” said Dan Szekely, Partner at EVP, a venture capital (VC) firm focused on early-stage B2B software companies in Australia and New Zealand, with around $200 million under management.

“I’ve seen first and secondhand reports from start-ups of terms being pulled and valuations getting pulled back.”

But private markets are less exposed to the crunch biting public markets, he suggests.

“The benefit of being in a market where the funds are already committed long term means we have a safety net – to an extent. There are billions in dry capital sitting within VC funds that have already raised money, and managers need to invest it to deliver the returns to investors within the ten-year timeframes they have to do it. So they need to invest, which is very different to the private market – where they can pull out fast, and the market tanks,” Szekely told Mi3.

“Our space doesn’t work that way, so the impact is less. But obviously, we’re not entirely free from the consequences of global economic meltdown.”

VCs like EVP – which last month led a $5m round in out of home verification start-up Veridooh – are focused on “high quality, high margin revenue and businesses that have the potential for profitability,” said Szekely. “Investors are less confident in those without margin to pay bills. They are looking to invest in businesses that have money [coming in] and can use it to survive.” Businesses with sound underlying economics and profitability are therefore “where more capital is likely to flow,” he added.

Shift to defence, profit

Szekely thinks the current correction is “healthy” following several years of froth.

“Investors were [piling in] at 30-50x multiples.” He said start-ups and their backers are realising “it will be very hard if not impossible to do a future [funding] round at a higher price. They will have to extend runways, stay out of capital markets because investors will not be supportive, and those businesses as prompted by their investors will have to look for healthier, slower growth.”

He suggests investors will seek “more defensible” start-ups over those trying to prove out questionable business models.

“If I pay $5 to acquire a customer, but that customer pays me $2, that is not economic,” said Szekely. Investing on the basis that the start-up thinks it can grow that revenue to $10 “is a high risk bet – you have to prove that before you run out of money”.

Hence funds like EVP specialising in SaaS businesses.

“They typically have 80-90 per cent margins – we have a portfolio of about 40 currently. During Covid a lot of them went through a dip. But many actually went profitable overnight: If you are a business that does $10m in revenue of which $8m is margin, there is a huge opportunity for profit if you can cut variable expenses,” said Szekely.

“There are not many companies in our portfolio that couldn’t go profitable overnight – which is why we focus on SaaS. If you are an ecom platform, you are only as good as your next month: If you turn off marketing, the growth falls off. If you have recurring revenue, you could lose everybody overnight, but then the recurring revenue would all be largely profit.”

Digital media metrics under spotlight

Fintechs with arbitrage-based business models appear to be taking the hardest hit. John James, founder of specialist growth consultancy Project X1AB, thinks there will be further casualties.

“I’ve heard firsthand of fintech start-ups getting massively squeezed. For them it’s harder to hide – it’s all arbitrage, inserting tech inside a transaction and clipping the ticket,” said James. “Some are now exposed.”

Increasing unreliability of digital media metrics has a direct impact on the VC crunch, reckons James.

In assessing current and future revenue-profit prospects, VCs look at two things in particular, said James – customer acquisition costs (CAC) and lifetime value (LTV). "Within that there is a lot of heterogeneity in terms of the customers you acquire – some are high yield and some are low.”

He thinks some now pressured start-ups, including some of those within buy now pay later (BNPL), “have inflated customer acquisition figures” using “vanity metrics” to fuel a growth narrative.

“What is hidden is that the cheapest customers to acquire are the shittiest [and some BNPL firms] have regressed into high credit risk customers to keep acquisition figures high. That creates bad debt and bad debt kills the company,” said James.

“The other part of this is that customer acquisition cost is really influenced by popular digital media – hence the best yields are often in stuff [the media channels] that everyone else isn’t using.”

The biggest channels harnessed in recent years have been search and social. “But privacy tracking changes are causing a breakdown in that feedback loop”, said James.

“So if I spend X, I don’t know for sure that investment has produced customers, whereas before I did. In some Google ad accounts, 80 per cent of all conversions are not visible any more – when they used to be really high. So the feedback loop is broken, you can no longer be sure of unit economics, it is a black box.”

The upshot is a return to mass media to drive growth, James suggests.

“So the old is new again. But there is massive lag because VCs have been fed incorrect figures – and as a result they are having to get other parties in to do due diligence.”

That presents an opportunity for firms that can accurately attribute media spend to returns.

“There are lots of different ways you can slice and dice CAC,” said James. “Even some of the big B2B software firms are now getting smashed because they have been found to be blending renewals into customer acquisition costs to make the CAC look good,” he added.

“I don’t think we’ll be swapping anything out. We have six direct investments, but they are all early stage. We have an unrealised portfolio value of around $2.5m. But we’re also invested in some early stage VC funds, pre-seed and seed – so cashing the first cheques of founders – and nothing has really changed there,” said Graham. “It’s actually a benefit, because we will probably get good valuations and the focus will be on solid business models, better diligence. It means we can take some rewards and keep investing.”

“Some are hiring great people leaving other start-ups; they can over-invest when others are squeezed and use a recession to build brand and build share,” he added. “Across the board, there will definitely be more conservatism. But any founder in one of those insulated environments is in a far more comfortable position than those out on their own.”

No pain, no gain

Thinkerbell founder Adam Ferrier thinks a market correction is necessary and will reduce wastage by start-ups, agencies and consultancies.

“If you’re building a brand on the hopes of what might be, rather than what you have now – there is always a leap of faith. Now those dynamics have shifted,” said Ferrier.

“In recent years, I’ve noticed a number of start-ups using other people’s money to try and grow … there have been a lot of consultants and a lot of power point documents that never went anywhere.” He thinks fintechs, including some of the neobanks spawned post-Royal Commission, were guilty of that approach.

“At the same time, we’ve been working with start-ups that have not relied on other people’s money – and we’ve seen those brands come to life and grow."

Ferrier cites 2BE, a proptech founded by former Westpac CEO and BeforePay chair Brian Hartzer, as a current example. (2BE helps older homeowners unlock equity to help their children or grandchildren get on the property ladder.)

“They haven’t relied on VC money and have taken a strong proposition to market in a sustainable way,” said Ferrier. “When the founders have a self-sustaining business model that is profitable from the get-go, people’s feet are more on the ground.”

Thinkerbell has blue chips and start-ups on its books. Ferrier doesn’t see the mix altering radically in the foreseeable and he thinks the broader washout could end up positive in the medium-term.

“It is good for the brand building industry. A correction will force a focus on making sure business models are advanced before VCs try to pump money into the next big thing, which feels akin to gambling. That is not a game we want to perpetuate,” said Ferrier.

“We want to build strong brands with strong business models behind them – and it’s easier for us to do that if we know we are building a business that is profitable, rather than one that hopes to be in the distant future.”

Profit before growth at all costs?

As the VC crunch turns the spotlight on business fundamentals, there is evidence to suggest small to medium sized companies (SMEs) that focus on profit and business fundamentals consistently outperform those going all out for growth.

A massive research study conducted by France-based IESEG School of Management found that across 40 per cent of European SMEs, firms that prioritised profit before growth at all costs were 2.5 times more likely to succeed. (Get a 60-second take here.)

The work builds on earlier research across Swedish and Australian SMEs led by Per Davidsson, Professor of Entrepreneurship and Founding Director of the Australian Centre for Entrepreneurship Research at Queensland University of Technology. Davidsson drew similar conclusions.

“It is not about maximising profit but about having a sound financial and product/business model basis before going for growth. The research shows that those who grow while having poor profitability are unlikely to become more profitable because of their growth; instead they are unlikely to be able to sustain the growth and end up having below average performance on both dimensions,” wrote Davidsson in response to questions on the research. “Those who first have above average profitability at modest growth are more likely to reach the enviable position of being above average on both dimensions.”

He stated the results of the studies “have been replicated with astonishing consistency across countries, industries, firm size and age classes, operationalisations, and analysis techniques. Yes, some ventures operate in winner-take-all markets where growing big fast is important to capture a large market – but even in this unusual setting, what proportion of those who try do you think actually succeed?

“The research strongly and consistently supports that "profit first" is more likely to lead to high/high performance and 'growth first" is more likely to lead to low/low performance.”

... Or keep going for growth to win?

Amanda Price, Head of High Growth Ventures at KPMG, suggests the profit-first approach is less applicable to start-ups.

"There's a huge difference between an SME and a start-up. What differentiates them is the path to growth. SMEs can't experience the growth start ups can – and for start-ups that growth is fuelled by capital. Look at Atlassian, it was not necessarily profit-focused for first few years," said Price. "Ultimately there has to be focus on profitability – but it's not top of mind for a lot of start-ups. Canva was initially free before launching a paid product. If it had to be profitable day one, there is no way Canva would be as big as it is now."

Shift to efficiency, but VCs 'not panicking' 

Price said VCs have "shifted to operational efficiency" in light of the crunch. "For the first time in four years we've had companies ask us to help extend their runway. We will see firms becoming more efficient around their capital, which is now more expensive, and it will be harder for them to raise, particularly if they don't have revenue insight."

While there will be more 'rightsizing' to come, particularly within some fintechs, Price thinks that is "probably not a bad thing". She suggests a contraction will be "short and sharp" but said reports of a VC-start-up death spiral are greatly exaggerated.

"We read about companies cutting 10, 15, 20 per cent of staff. But the last few years have been a growth at all cost mentality – they put on more people to chase down every deal," said Price. "So there was a bit of fat in those businesses going for growth. When that slows they naturally bring the business down to a smaller size. So they are shedding staff and getting back to where they need to be," she added.

"There's definitely been a shift over the last few months but there have been mixed messages in the press around what is taking place. It sounds very doom and gloom, but working with the VCs, we are not sensing a great deal of panic. It's part of the economic cycle and we have been through it before," Price suggested. 

"A lot of VCs realised the market was starting to turn and got a lot of their companies to raise capital over the last 3-6 months. As a result, a lot of them are in a good place with capital and many of the larger VCs raised new funds, so there is a lot of dry powder that will need to be deployed. It will be an interesting time, but I think the Australian start-up market is pretty strong."

Healthtech, deeptech, climatetech boom

Healthtech is one of the more resilient sectors. "Two years ago, we didn't have any healthech in our portfolio," said Price. "Now it is one of the top categories – it's going through the roof."

Climatetech and deeptech – "quantum computing, the stuff that maintains secrets for CSIRO" – are also largely unaffected. "Investors take a long-term view on climatetech. It is quite capital intensive, but those sorts of areas won't be impacted," said Price. "Climatetech is huge, it will power through, because the world is standing on a burning platform. We have to do something and an economic downturn won't change that."

Brand building, attribution opportunities

Price, who spent 15 years in marketing and media before becoming a start-up specialist, agrees with John James that sharper digital metrics and more accurate attribution of marketing and media investment would benefit both VCs and start-ups.

"Attribution is hard. Having run a start-up within KPMG, we are looking to better capture returns from marketing investment. When people start talking about capital efficiency, you want tools that enable better visibility of the business end-to-end. Marketing and attribution for sales – which channels and investments are most effective – requires a number of tools so people can understand which levers they can pull. So we will see an increasing need for those tools." 

Otherwise, brand budgets may be axed, especially where firms are preserving cash to ride out the storm.

"Where capital is constrained ... we've all been through times where marketing budgets are cut," said Price. "But other firms are in a good position and in my view will be really aggressive [in marketing] to try and win their category while others potentially can't afford to do that," she added.

"Differentiation through brand will still be hugely important. If it was me, and I had the cash, I'd use this opportunity to win."