From COVID-19 to rising inflation to increasing energy costs related to the war in Ukraine, start-ups are experiencing an unprecedented and challenging environment. Investors have become more cautious about deploying funding, and they are questioning the value of many hypergrowth business models. In the first half of 2022, the number of successful global IPOs dropped by about 50 percent compared with the previous year,1 leaving start-ups uncertain about how to continue their equity story and fuel further growth.
McKinsey’s Markus Berger-de León and Jerome Königsfeld sat down with some of Europe’s leading venture capitalists (VCs)—Florian Heinemann, founding partner at Project A Ventures; Christian Saller, general partner at HV Capital; Jenny Dreier, investor at EQT Ventures; and Alex von Frankenberg, managing director of High-Tech Gründerfonds—to get their outlook on the next two years and discuss what European incumbents, VCs, and start-ups can do to emerge from these uncertain times stronger than before.
Key insight #1: Growth will continue to slow, but a second dot-com bust is unlikely.
Jerome Königsfeld: What is your outlook for the next two to three years? How do the current challenges compare with previous crises such as the 2000 dot-com bust or the 2008 global financial crisis?
Florian Heinemann: From an economic perspective especially, the rising inflation is worrying. This was not the case in Europe in 2000 and 2008, where economic effects could widely be mitigated by a liberal monetary policy. The challenge now is that with current double-digit inflation rates, this mechanism is on pause. Over time, inflation is likely to negatively influence consumer sentiment, which would be especially challenging for consumer brands. While it’s difficult to predict how long the current situation will last, I am optimistic that, for the start-up ecosystem, it will not be as bad as the dot-com collapse.
Christian Saller: If you look at available money within VC funds today, we are at an all-time high, and this money needs to be deployed at some point. This was not the case during previous financial crises. Business models are also more solid today than during the dot-com bubble. Most start-ups paid attention to unit economics before the current crises and have fallback options for slower and more sustainable growth. Of course, in some cases, such as quick commerce, there may not be a clear path to profitability, which will become more challenging as the crises continue.
Key insight #2: Funding will remain available, especially for early-stage companies and scale-ups that can prove sustainable unit economics.
Markus Berger-de León: What’s your view on funding? What start-ups will still get funding, and who will dry out?
Jenny Dreier: The funding market has tightened over the past few months, especially in the United States. However, this might be temporary, as VCs are sitting on a record pile of committed capital. There is still plenty of funding available for early-stage rounds. When we look at how start-ups approach funding now, the main difference is that companies are raising money for longer runways and considering the path toward profitability more than they did two years ago. VCs need to be willing and able to make longer-term investments and provide additional capital for follow-on rounds if needed.
Top-line growth was imperative for start-ups in 2021, driven in part by investors. Now, for many, it’s challenging to make a rapid shift and prove that they can combine revenue growth with sustainable unit economics.
Alex von Frankenberg: Getting investments after Series B has become quite difficult, and valuations have dropped significantly. Software as a service (SaaS) annual recurring revenue multiples highlight this drastically: they decreased from a range of 30 to 40 to 10 to 20 or even less. There are three causes. First, there is less competition, especially because many large US growth funds have reduced their activities. Second, VCs must factor in that large exits will become more difficult to realize in the coming years. Third, only start-ups in need of funding currently raise money, and they have become humble with their valuations.
Key insight #3: We are in the era of cleantech, energy, security, and supply chain start-ups; VCs will continue to court start-ups in these sectors.
Jerome Königsfeld: Which start-up sectors are enjoying the biggest tailwinds amid the current crises?
Florian Heinemann: Rising energy prices are driving inflation; this, in combination with an increased awareness of climate change, is a massive tailwind for cleantech. The sector includes all start-ups focusing on the generation or smarter distribution of energy and on topics such as carbon capture and more-efficient green construction.
Even before the current crises, geopolitical tensions fueled the growth of start-ups that support countries in their pursuits of sovereignty and security through endeavors ranging from chip development to technology that improves security, especially cybersecurity. The war in Ukraine has further accelerated this trend, especially within Europe.
Alex von Frankenberg: Topics like energy, IT security, and supply chain management but also biotech are trending. It is great to see that start-ups are tackling the current core problems of society and that investors are providing significant support in these areas.
Many of the business models in cleantech have a strong operational component, such as installing household energy storage. The question is whether VC investment is the right funding instrument for these business models. Debt financing or private equity (PE), for example, could also be options, as they reflect lower risk and potentially slower growth than asset-light SaaS equivalents. While the valuations of VC darlings like SaaS businesses may have decreased, the business models in general still work and will continue to work well.
Key insight #4: Founders will switch their focus from unconditional growth to building sustainable businesses.
Markus Berger-de León: How will the start-up scene change during these current challenges?
Christian Saller: We come from a time in which, as crazy as it sounds, fundamental economic considerations have been sacrificed for unconditional growth. This view was driven by too much money in the market, pushing up burn rates and valuations into unrealistic spheres. It was about time for multiples to drop.
Now, founders have a chance to concentrate on building a sustainable company instead of excessively focusing on growth stories and doing one fundraising round after another. Those who survive this volatile landscape will be healthier and stronger.
Jenny Dreier: There is a saying that the most exciting companies are born in times of crises. Looking at today’s megatrends, such as cleantech, we see a clear shift away from the next shopping app or direct-to-consumer offerings toward ideas that have a truly positive impact on society. This move is increasing the reputation of start-ups as drivers of prosperity, progress, and secure jobs.
Over the past several years, we experienced a strong founder-led market where VCs often ended up having to make very quick decisions with limited due diligence. Today, there is a return to more rationality; VCs are able to go deeper, gather more data, take time to run due diligence, and make better-informed investment decisions. We are also able to spend more time with founders, coach them, and invest at more sustainable levels. EQT Ventures just closed a new €1.1 billion fund, and I am more confident than ever that this will be a good vintage.
Key insight #5: Start-ups can negotiate unique marketing and media deals, increase talent density, and pursue programmatic M&A.
Jerome Königsfeld: What opportunities are arising for start-ups amid these crises?
Florian Heinemann: Operationally, start-ups have a great opportunity to renegotiate media deals to reach new target groups. With reduced media spend across the market, fixed-cost heavy channels, such as TV ads, will come under pressure and may be willing to make highly discounted deals with start-ups.
The buy-and-scale approach is still massively underestimated in the start-up scene. Start-ups can profit from dropping valuations and pursue M&A deals, either for product expansion or to add adjacent products and services to their solution, as they rapidly expand into new markets. This strategic approach to M&A has made Urban Sports Club and Delivery Hero leaders in their markets.
Christian Saller: The current situation presents probably the best opportunity in years to recruit and retain top talent. Our portfolio companies report not only better people applying for jobs but also more realistic salary expectations, especially for sales and tech. And we will see even more need for restructuring in the start-up ecosystem. Healthy start-ups can use this moment to recruit to fill critical roles and increase talent density.
It’s also a great time to double down on reducing customer acquisition costs. When four or five VC-funded competitors are acquiring customers through the same channels, none of them will realize sustainable unit economics. With much less competition, start-ups can explore new channels and make existing acquisition channels profitable.
The importance of using M&A to gain market share will also increase. In the past, founders often requested unrealistic acquisition prices, which, unsurprisingly, frequently blocked deals. Now we have a chance to execute sensible mergers that will help start-ups reach profitability through consolidation of crowded markets. This is an opportunity to both grow and perform an exit with a reasonable return for investors.
Key insight #6: The current crises call for visionaries with sharp analytical skills who can push top-line growth while ensuring the bottom line is under control.
Markus Berger-de León: What traits will help founders manage these current crises?
Alex von Frankenberg: For every founder younger than 35 years old, this is the first economic downturn that they are experiencing, and it is blocking monetary stimuli to fuel growth. In the past two years, we saw many founders who were especially great visionaries and storytellers exciting investors in record-breaking financing rounds. Now they must prove that they can also navigate the hardships.
First, they must have acute analytical skills and push positive unit economics. Business models that require large investments will be hard to fund in the next few years, so founders must build confidence that their start-ups can manage their top and bottom lines. Second, founders must adapt flexibly and rapidly to changing external conditions by reducing the burn rate when demand and funding ebb and quickly scale teams when the economic tide shifts upward. Third, founders need to take a long view to derisk unforeseeable changes in the funding environment. Start-ups should raise funds for a two- to three-year runway and develop plans to potentially extend their runway by managing costs and prioritizing profitable sales channels.
Christian Saller: The fundamentals of what we look for in a founder have not changed. Being a strong visionary who inspires team members, investors, and customers alike is still required. However, especially in the current market turmoil, we look for well-rounded, humble people who want to build sustainable businesses and combine growth with positive unit economics. They must be able to cope with setbacks. Experienced founders who successfully managed crises before will likely have a competitive edge.
Key insight #7: For PE investors and corporates, M&A opportunities will increase.
Jerome Königsfeld: How will corporates and PE investors react? Will we see a new spree of M&A?
Florian Heinemann: In previous years, short-term multiple arbitrages were crucial for PE investors. In a market with dropping valuations, this practice no longer works. PE investors must get operationally involved again and transform companies to create value. For investors willing to get in the weeds, the lower valuations present an opportunity. However, they need to have stamina, as nobody knows how long the crises will last.
Jenny Dreier: From a corporate perspective, now is a great time to pursue investments in or acquisitions of start-ups. In the past, founders could be very selective about who could invest in their company or what kind of cooperation they would accept, and investment rounds moved very fast. Often, founders categorically ruled out corporate investments or acquisitions at an early stage. But the situation has changed with capital becoming more expensive and harder to come by. More founders will consider investments from corporates or their VC arms. And corporates might start with a smaller investment to have a foot in the door and consider a full acquisition at a later stage.
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