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INNOVATION ECONOMY

Nine ways the startup world is reacting to markets tanking

Whatever you call the tumble in the public markets that began in November, its impact is beginning to be felt in the world of tech and biotech startups.MIT Video Productions

Correction? Recalibration? Shock?

Whatever you call the tumble in the public markets that began in November, its impact is beginning to be felt in the world of tech and biotech startups.

Venture capitalist Michael Skok uses the phrase “reality shock” to describe what’s happening. For much of the pandemic — and for a good stretch before — capital has been flowing freely to startups. Those that attained success and scale have been able to go public. But in April, it was like someone flipped on the lights, abruptly ending what had been a really fun party.

“You had an incredible amount of stimulus money pumped into the market, with the resulting inflation,” said Skok, founding partner of Underscore VC. “The war in Ukraine is not going to be a short-term crisis,” he adds. And with China’s zero-COVID policy and lockdowns causing new supply chain snafus, you’ve got “de-globalization going on,” Skok said. “People are returning to local manufacturing and pulling back from China.”

I’ve been talking to Skok and other veterans of the Boston startup scene, people who have dealt with the dot-com crash of 2000 and the Great Recession of 2008. Based on those conversations, here are nine things that typically play out in the startup world when markets turn south, and are beginning to happen now.

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  • Companies get disciplined about their “burn rate” (how much money is spent each month) and find ways to “extend the runway” (the amount of time before cash is depleted) become a key focus. “There’s a reattachment to fiscal discipline,” said Richard Pops, chief executive of the Waltham biotech Alkermes, at a recent conference. “A lot of companies will not make it through this cycle. But the ones that come through will be stronger.”
  • Fiscal discipline will likely involve layoffs at many companies. With a talent market that is still tight, and record levels of inflation, “you can’t do an across-the-board salary cut,” said Michael Greeley, managing partner of Flare Capital Partners. “You have to remove people, and keep the remaining people at their existing salary levels.” In recent weeks, local companies such as Spero Therapeutics, Akebia, and Genocea Biosciences have handed out pink slips. “A lot of startup employees are going to get their first real taste of less employee-friendly policies,” predicted Eric Paley. “Layoffs, less flexibility over work from home, more scrutiny of expenses, and fewer perks.” Paley is a partner at Founder Collective, a Cambridge venture capital firm. (In both 2000 and 2008, he was running a tech company.)
  • Hedge funds and so-called “cross-over” investors who have been pouring money into privately held tech and biotech startups are taking a breather, removing a key source of capital. Instead, they’re looking to do “fallen angel” deals, Greeley said — publicly traded companies whose stocks are now deeply discounted.
  • The “IPO window” — the stock market’s appetite for newly listed companies — is effectively closed. That means startups will need to stay private longer, or seek to be acquired by larger companies, which will have the upper hand in negotiations. “It’s a buyer’s market now,” said Kees Been, a longtime biotech industry executive.
  • Because companies will need to stay private longer, venture capitalists must carefully analyze how much cash they have left in their pockets, and think about how they will allocate it to companies they’ve already backed to help them endure a difficult stretch. Venture capital money has not suddenly vanished — Greeley’s Boston firm raised $350 million late last month, for instance — but VC firms can no longer assume lots of other investors will be clamoring to put money into their startups when they need that next infusion. Greeley said most VCs have been doing the math in recent weeks to figure out how much money they need to reserve to keep their most promising companies afloat. Companies still struggling to find customers or get to profitability may be told that there’s no “follow-on” funding available, or less than they’d hoped for. “That is a really difficult calculus,” said Greeley. “You may really have to reduce your support of a company that might be promising.” He said he tries to communicate the situation clearly to entrepreneurs. “We want them to start taking corrective actions,” and cutting any costs they can, he said.
  • You’ll see mergers of companies that have been developing similar products and selling to similar customers in an attempt to improve their chances of success. Some longtime observers of the startup world call this scenario “tying two rocks together and hoping they will float.” It doesn’t always end well.
  • Some of the most promising tech and biotech companies will still be able to raise money through this period, on favorable terms. ”Early-stage companies that have focused on capital efficiency will have a significant advantage over the coming three to five years,” wrote entrepreneur and investor Andy Palmer via e-mail. “Private capital will continue to flow to profitable, cash-flow positive companies that are growing as fast as possible.” Companies that can continue to grow during a down economy, Palmer said, “will probably receive an inordinate amount of valuation and liquidity” when the IPO market returns, or when bigger companies are looking to acquire.
  • Some companies that are able to raise money in the current climate will endure “down rounds,” when the company’s valuation takes a step down rather than up. That means investors effectively get a larger slice of the company for their dollar. Often, funding rounds in tough times include various clauses and preferences that make it easier for new investors to get paid first if a company is acquired, but they can work to the disadvantage the company’s founders and earlier investors, Greeley explained.
  • Entrepreneurs who decided to build businesses the old-fashioned way — without relying on venture capital, or dreaming of an IPO — are patting themselves on the back. At ButcherBox, an online vendor of meat products, there’s no need “to look pretty for the next round of funding,” said chief executive Mike Salguero, so the company can instead stay focused on profitability and customer needs. Due to inflation, ButcherBox has had to raise prices twice in the past eight months, Salguero said, so he has been scrutinizing operations to find ways to deal with rising costs, including fuel prices and transportation. The company has 180 employees, half of whom have been hired over the last two years, “and we are continuing to hire at a strong pace,” Salguero said.

How long does this downturn last? Paley noted there have been transitory scares, like the market panic in the early months of COVID, or dips related to government shutdowns. But he predicts this period of “displacement” will be more enduring.

“Everything will deflate over a year or 18 months,” Skok said. “That will cause all of the right behavior around use of capital.”

“The economists are better at predicting than I,” said Palmer. “But as my banker friends who make all their money on volatility always remind me: what goes down must come up at some point.”

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Scott Kirsner can be reached at kirsner@pobox.com. Follow him on Twitter @ScottKirsner.