Avoid the 'bridge round to nowhere'
More than twice as much capital was requested by startups than was supplied in 4Q22, according to Pitchbook. Even though this analysis was for the US market, our insights show that the European market 'correction' is running only one quarter behind the US. The phenomenon of demand outpacing supply holds true for all stages of the venture market: startups are seeking between 50% (at early-stage) to 150% (late-stage) more capital than VCs are supplying. This huge imbalance, which started back in 2H22, has significant implications for startups - not least the increasing likelihood of an internal bridge round being required. If new investors aren't going to come in then the existing investors must step up. And, most of the time, they really don't want to. Yes, funds usually carry 'reserves', but these are really for follow-on investments in 'up rounds'. By now, most VCs will have triaged their portfolio and already decided which startups they will likely continue to back in the face of current macro-market conditions. When founders raise the topic of a bridge round, they are quickly going to find out which triage bucket their company is in. This could depend on the type of bridge round.
VC, Jason Lemkin, describes 3 types of bridge: The '0x', '1x' , and '10x'. The '0x Bridge' is the panic round. Founders suddenly see only a few months of runway remaining and make a last-minute appeal to investors for more cash. If they are really lucky they get it. But with no realistic plan to hit the next big milestone - and associated equity round - they usually end up back where they started a few months down the line. VCs call this the 'bridge to nowhere'. Then there's the '1x Bridge'. This is where growth has been slow for a while and so the prospects of high growth look slim. Startups are flywheels and momentum engines. If they couldn't take advantage of the hot markets of 2021/22, they are probably going to find it a lot harder now. But that doesn’t mean these ones will fail. A $10m business growing at 20% is still a very real business. Just not one likely ever to be worth $1B and so 'return the fund'. But a VC could still get their money back in a more modest exit. If a small second cheque helps avoid a write-off, it can be worth it, and so these deals are quite common. Finally, there's the '10x Bridge'. VCs saw a lot of these when Covid struck. Even top-tier business were hit badly. But VCs knew these were still 10x to 100x return prospects, so bridge deals were done - often very quickly and without fuss - to protect these golden geese.
So how should founders pull off a low drama bridge round? First and foremost, operate on 'no-surprises' basis. Make sure investors know your cash-out date and the risks that could accelerate this. If you do this regularly, good VCs will start planning for a bridge round even before you do. Second, have a plan. Show you are running towards the problem not away from it. Before you get within 9 months of cash out, you should be presenting a credible plan to the board and the lead investors that shows a clear route to extending the runway on the back of delivering key milestones. This is going to involve a new (externally-led) funding round, cost cutting, or both. Third, avoid the Highly Delusional Plan at all costs. Don't present a plan based on a best-case outlook as this will undermine your credibility. This is another version of the bridge to nowhere: It looks good, but it will never happen. VCs simply won't sponsor such a plan though their investment committees with the fear of looking stupid (FOLS). As Lemkin puts it: "The bottom line is: a real plan, maximum transparency, and taking early action helps increase the odds it’s not seen as a 0x Bridge." And if you can, pitch it following some good news. Get the optics right - it must look like a '10x' in waiting.
Usage-based pricing takes off
Three out of five SaaS companies now have some form of usage-based pricing (UBP). This is almost 3x the level of 2018 and represents a seismic shift in the business model of software companies over recent years. Research into 3,000 private SaaS companies, undertaken by Boston-based VC, OpenView Venture Partners, shows that 61% will have adopted usage-based pricing by the end of 2023 and a further 21% will be testing it. As pricing gets more complex, we’re seeing the rise of the modern pricing tech stack, with the transition to hybrid pricing models combining subscription and usage-based. While UBP models have become the norm in Infrastructure (e.g. AWS, Azure, GCP), they’re also found in Middleware (e.g. Stripe, Twillio, Plaid), Applications (e.g. Slack, HubSpot, Eventbrite), and Vertical Apps (e.g. Shopify, Autodesk, Procore).
There are 3 key drivers in the rise of usage-based pricing: 1. Software increasingly automates manual processes. The more successful a product is, the fewer user seats a customer needs. i.e. Seat pricing doesn’t scale with the value of automation. 2. AI takes automation a step further, eventually eliminating the need for whole teams of people for ongoing tasks. i.e. Monetisation can no longer be tied to human users of a product, and 3. For many of the fastest growing software companies, the value is in the API— software talking directly to other software—rather than the UI. i.e. There doesn’t need to be a user to see value. And companies that are making the shift are seeing the benefits. OpenView figures show that compared to a broader SaaS index, usage-based companies are seeing faster revenue growth and the highest net dollar retention. This is one of the reasons that investors are increasingly keen to evaluate pricing models during due diligence, especially in enterprise software.
UBP is becoming the core business model of many Product Led Growth (PLG) businesses, where companies get paid as customers use their product. Despite market uncertainty, usage-based companies are heavily investing in PLG. 87% of those with a largely usage-based pricing model expect to increase their PLG investments this year compared to 69% of more traditional software companies. Usage-based companies are focusing their PLG investments in two big areas according to OpenView: (1) building for openness, allowing users to easily connect their products; (2) providing value to end users, not only executive buyers. For these reasons, UBP clearly reduces the barrier to entry for customers but the tradeoff is that revenue growth may be more volatile, being linked to the fortunes of software companies themselves. But as the latest research from Gartner shows, even as Inflation continues to erode consumer purchasing power, overall enterprise IT spending is expected to remain strong through 2023, with Software growing 9.3% to $856B. This is a really bright spot on an otherwise uncertain horizon.
Critical Mass Theory of startups
On the startup to scaleup journey, the timing of market entry can have a major bearing on the fate of the business. No matter how compelling the product or team, entering a market too early could mean months or even years of waiting for the wave. Enter too late and the wave may have passed. You'll then be fighting constant battles with competitors who have moved faster. Spotting the tipping point for a nascent market, when external factors conspire to create the first surge in demand, is a crucial part of the founder's insight. Understanding these external factors is as important as understanding the internal factors such as the product, the team, the go to market plan, and the business model. This may feel counterintuitive as we are often encouraged just to focus on the things we can control, not the things that we can't. But in the startup, timing is everything. Successful founders know how to leverage market conditions to unleash powerful, sustaining change.
Early stage VC, NfX, describes these market factors in their Critical Mass Theory of Startups, as the tipping point when a product or market goes under rapid transformation, seemingly overnight. This moment arrives when there’s a minimum threshold of three preconditions: Enabling Technology, Economic Impetus, and Cultural Acceptance. Tech founders, who are constantly on the lookout for a better way to do things, are likely to be most in tune with the first of these. Their insights should provide a clear understanding of the trajectory of emerging technologies, and when these technologies are on the cusp of a transition that will enable transformational product experiences. Macro economic forces can have a huge bearing on costs, a classic case being economies of scale. For example, Moore's Law, which foretold lower costs for the same amount of processing power, created an opportunity for the consumer electronics revolution. And finally, Cultural Acceptance, often the most underestimated of all preconditions. As behaviours change, the viability of a market category can change as well. Rapidly evolving social media trends are one of the most obvious examples.
In the post-pandemic world, investor sensitivity around external market factors has become significantly heightened. Founders must give greater consideration to these when preparing their investment propositions. VCs believe that the company that can achieve scale at the critical mass point will win; this is what Apple did with the iPhone. Amazon did this with eCommerce, Google did this with search, and virtually every other category-defining company in history has also done. Nfx partner, Pete Flint, perfectly captures this sentiment: "This is where the first-mover (or last-mover) advantage paradigm gets it wrong. What’s important isn’t whether you’re earlier or later than your competitors on an absolute basis – rather, it’s all about who enters the market closest to the critical mass point. It’s at this point when technology, economic and cultural forces can combine to enable explosive growth for founders."
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