Tech companies are especially vulnerable during an economic downturn, as most of the early-stage enterprises aren’t profitable. Instead, they rely on venture capital investments to cover the soaring expenses needed to drive rapid growth. This is much more difficult to achieve when consumer demand slows. 

Total global VC funding in Q2 2023 dropped 11% from Q1, while SaaS-specific valuations have steadily declined since the beginning of 2022. Tech start-ups will need to not only overcome wider economic challenges, but also find a way to survive a decrease in funding opportunities.

Is there a clear path to profitability in your growth plan?

This is the question that all investors are now asking early-stage tech startups, following the implosion of the stock market earlier this year. Even just a year ago, there was little talk of profitability being a primary focus, with more emphasis placed on high growth instead, but the present day sees the economic environment as very uncertain, with venture capital firms applying more granular due diligence when it comes to investing in startups.

This has shifted the balance of power from entrepreneurs to investors: this shift sees companies and startups needing to make significant changes and needing to make them now in order to become more attractive to investors.

Does the Rule of 40 still apply?

The Rule of 40 states that for healthy SaaS companies, if the growth rate were to be added to their profit margin, the combined value should typically exceed 40%. The 40% rule implies that early-stage companies with either low or negative profitability could still be reasonably priced at a high valuation multiple if their growth rate can offset their burn rate. While certainly a generalization, the Rule of 40 had increasingly gained credibility for analyzing a company’s operating performance.

Before the financial crisis, if a company could demonstrate, for example, a 39% growth and a 2% profit, they still had a good chance to attract investment, but it is close to impossible now. If a currently non-profitable company is hoping to raise capital now, it must have “a great story” – a sustainability angle or something else that will be attractive itself. Whereas if you’re a “regular”  e-commerce company currently not making profit, it will be exceedingly difficult.

Do the growth indicators still matter?

If previously all SaaS companies were focused on and talking about growth, now the shift has been towards operational excellence. They’ve gone from sales and revenue-generating activities to focusing on understanding all the implications the operative decisions have on the company going forward. This can also be clearly seen when it comes to the profiles we, as an executive search expert, offer to our clients: if previously the desirable CEO profile was a candidate who had a great understanding in how to drive traffic and convert it into customers, now the more in-demand CEO profile is someone who is familiar with all the different aspects of running a company (including Balance sheet understanding) – that’s a much more attractive profile for the potential investors.

If you now look at the list of the most interesting SaaS companies in Europe from 2021 and compare it with the same list from 2023, you’ll find that at least half of the ones present in the 2021 list are gone. They’re not bankrupt, but they’re no longer seen as so successful. And that’s because back in 2021 we were looking at the companies which grew 500% as highly successful, whereas now the ones considered successful are the ones who can show good processes and profit.

What’s changed when it comes to leadership of early-stage tech startups?

Now it’s the CFO role which has gained importance massively. Very often it’s the investors who aim to replace the existing CFO for someone with a better grasp on the operational excellence and profit generation, and quite often the existing CEO is then too replaced as a consequence. It was very easy to raise capital before because the investors weren’t as hurt by the results, but that has changed.

Fintech is a sector that has been very much hurt by other changes too – it is not just the extensive competition that they face, but there has also been a lot of change when it comes to regulations, compliance and the costs that are required to implement them. It works the other way round now too – a couple of years ago candidates were very interested in leadership positions in the Fintech sector, but now there is a lot more caution and candidates are trying to find out as much details as possible about the company where the position is offered.