Investors focus on revenue and customer base as valuations take a back seat

Deals are still within reach for startups with a compelling pitch and solid fundamentals

This month, Natalie Duncan (pictured) faces the biggest test in her young entrepreneurial career. The co-founder of Bug Mars, a Toronto-based company that’s developed an AI system to help agricultural companies increase yields of their cricket farms, is looking to raise seed money. She doesn’t want to reveal how much she wants or how many investors she’s pitching, but Duncan plans on talking to a lot of people.

“I’ve never pitched in person,” says Duncan, who started her company in 2020. She got the idea for her platform, which uses cameras and sensors to keep track of insects, after the crickets she was farming for her own consumption started going missing. “I’m excited, but I’m nervous — a couple of years ago I was just trying to eat crickets, and now I’m pitching.”

If this were last year, when investors seemed to be doling out money to almost any tech company, she’d face much better odds. Now, with publicly listed technology stocks taking a massive hit over the past 12 months — the S&P 500 Information Technology Index is fell 22 per cent last year — and venture capital and private equity firms writing down the value of their investments, raising money is much more challenging. According to KPMG, global venture capital investment fell in the second quarter of 2022 to $87 billion from $136.8 billion a year prior.

Duncan is well aware of the fundraising challenges startups and other tech companies face, but she’s not deterred. “I may be more optimistic than I should be,” she says, adding that her company’s tech helps farms increase insect production both for poultry and human consumption — crickets are a popular food overseas. “My thought is that regardless of what’s happening in the economy, people need to eat.”

Focus on fundamentals

While Duncan is going after seed money — it’s many of the Series A and B rounds that have dried up — if she makes a pitch that emphasizes her company’s potential and sticks to the fundamentals, then she could wind up with a windfall.

Over the past few months, investors have stopped focusing on valuations — a metric that indicates how much a business is worth — when determining a company’s potential. They’re now paying more attention to numbers like revenue growth, sales and customer acquisitions. While it may seem as though investors should have been concentrating on the latter all along, in the frothy global markets of the past decade too many wanted to drive up value in anticipation of a big exit, rather than ensuring the business was any good in the first place.

Craig Leonard, managing director and general partner at Graphite Ventures, has seen this story play out before — during the dot com bubble and at other market peaks. When valuations get too hyped, “party rounds” form, he says, which causes investors to make a quick deal, often at the expense of due diligence. “These rounds are competitive, and investors get into businesses that they’re not truly informed about at high valuations,” he explains. “The corrections can be pretty harsh.”

According to Canadian Venture Capital’s most recent report, $869 million of VC money was invested across 144 deals in Q3. That’s comparable to Q3 2020, but down from 2021’s record-breaking year. Seed and early-stage company valuations are still elevated, with $152 million invested across 62 deals — double 2020 numbers and on pace to match 2021’s year-end figures. While the strong seed figures could be good news for Duncan, every investor has become more discerning, says Leonard.

Hype has never factored into Leonard’s investment decisions, he explains. He’s always invested in “somewhat” conservative businesses, he says and is partial to metrics that have an intrinsic value to them, such as recurring revenue, numbers of customers and total revenue. “We don’t get caught up when there’s a pile-on of investors jacking up the price,” he explains. “Valuation is not an absolute indication that a company is doing well. It’s an indication they can tell a story well or they can attract investors, but it doesn’t mean they’re acquiring customers or their sales engine is firing on all cylinders. For us, as a business, the fundamentals are what matters.”

Cash is king

With investors shifting their attention away from valuations, startups and other businesses may have to settle for raising less money than expected, says Chris Albinson, managing director of venture capital company BreakawayGrowth and CEO and president at Communitech, a Waterloo-based organization that supports startups. “For companies that need to raise capital, it’s going to take longer and be more challenging,” he says. His advice to startups: Have 18 months of runway to get through the end of next year.

Still, companies are raising money — and it’s the ones that can show real progress in their businesses that will come out ahead. Albinson points out that thanks to lower valuations, growing operations can now acquire competitors and other operations at cheaper prices, too. For instance, in August, Waterloo-based software company OpenText purchased a U.K.-based software company for $6 billion, while in October Kitchener-based traffic infrastructure-focused tech company Miovision bought a Pittsburgh-based tech company for an undisclosed sum.

“We’ve been saying since last January that the environment is going to get bumpy and companies should have cash on hand to navigate that,” he says. “But for companies that have successfully planned, we’re seeing them get pretty aggressive on acquisitions. If the fundamentals of the business are strong, and they’re prepared, now is an opportunity to be aggressive, and actually come out ahead.”

On the flip side, for companies that are burning through cash or can’t prove to investors that they have a solid business worthy of investment, “it’s going to be a very tricky environment to finance themselves in,” says Albinson. “They’re going to have to get leaner a lot faster and capital is going to be more expensive — both debt and equity.”

While Leonard agrees the market environment has become more challenging for those seeking investments, ultimately, less focus on valuations puts less pressure on investors and founders to have pristine performance. “If you have a more reasonable price then you don’t have to hope that everything evolves perfectly,” Leonard says. “You can also take that additional time to dig in and get to know the founders before making the investment. So that’s favourable for us, but it’s also better for the companies. You don’t see a lot of founders saying, ‘I will take a lower valuation because I want to be able to grow into it.’ Now they will.”

Despite the changing investment landscape, Duncan, who wants to bring insect farming out of rural areas and into city centres (closer to the people who might consume them), says she hasn’t made many adjustments to her pitch. However, the shifting market environment has resulted in her narrowing her focus to certain kinds of investors. Before, she might have pitched to agri-food, cleantech and biotech investors, she says. Now she’s interested in circular economy VCs and those interested in smart city technology. “The government is supplying more money to hubs focused on these initiatives,” she says explaining why she’s approaching circular economy investors. “But the investment landscape has shifted, too, so we need to go where we fit.”