How to Avoid the Startup Death Spiral

Remember how good 2021 felt as a startup founder? Raising startup funding was like being a kid in a candy store – it felt limitless and exhilarating. Capital was abundant, valuations soared and it seemed like the sun would never set on the empire of innovation and entrepreneurship.

Fast forward to now, and the landscape looks starkly different. In fact, many startups are currently ensnared in the dreaded Startup Death Spiral, a situation every founder hopes to avoid.

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How the Spiral Begins

What seemed like a minor adjustment in market sentiment as interest rates began increasing in 2022 has snowballed into a full-blown crisis for many startups, which have experienced significant valuation declines in the past 18 to 24 months. 

Startup Death Spiral isn’t just a catchy term; it’s a harsh reality that has painful consequences. It begins with a significant decline in valuation, which can feel like the rug has been pulled from under your feet. This fall in valuation decline impacts everything, including employee morale, operational productivity, investor confidence and the broader market perception of your company.

The transition has been stark and painful. The venture capital frenzy in 2021, where $348 billion was poured into U.S. startups, has now receded to a mere shadow, with 2023 seeing a drastic reduction to $171 billion. This contraction wasn’t just about the numbers; it signified a seismic shift in market sentiment and investor confidence.

The influx of easy money during 2021 and the subsequent years came with a price. Startups made decisions that, in hindsight, were akin to building castles on sand. They burned cash as if it were monopoly money and were not prepared to build a profitable business. The bar was so low that enterprises with no shot of long-term success were able to clear it. 

What has happened since these heady times is sobering — IPO volumes have plummeted and venture capital deployment has shrunk considerably.  Raising capital is much more arduous with a much higher cost of equity, smaller average check sizes, longer times to get to deal closing and a noticeable drop in deal values across the board. 

 

The Data Tells the Story

The numbers paint a bleak picture. IPO volume is down more than 90 percent over the past two years, eliminating the public market exit option for many companies.

According to data from the Q4 2023 Pitchbook – NVCA Monitor, the average size of first financing deals plummeted to a six-year low of $14.3 million in 2023, a stark contrast to the $24 million peaks of 2021 and 2022. Similarly, early-stage deal values more than halved from $87 million in 2021 to $40 million in 2023. Late-stage ventures fared only slightly better, with deal values falling from $154 million to $80 million in 2021, a drop of 48 percent.

The Thomson Reuters Venture Capital Index, a barometer for VC-backed company valuations, underscores the turbulence, showcasing a dramatic 60 percent fall from its November 2021 zenith to its nadir a year later. Though there’s been a rebound, valuations still linger nearly 30 percent below their late 2021 heights.

 

A Cascade of Consequences

The initial blow to valuation often stems from macroeconomic shifts like the interest rate hikes in 2022, which reduced investor risk appetites and triggered a stark valuation decline. This devaluation shock is the catalyst that sets off a domino effect.
 

Talent Exodus

At the heart of any startup are its people. When your company’s valuation craters, the very fabric of your team is at risk. Key players – seeing the value of their equity compensation evaporate – start looking elsewhere, leaving you to navigate these troubled waters with a skeleton crew. The devaluation leads to a mass exodus of key employees. With their once-lucrative equity now sunk deeply underwater, employees will seek stability and better compensation elsewhere, often within the welcoming arms of larger incumbents. 
 

Operational Constraints

Following these events, you may face operational constraints characterized by budget reductions, scaled-back marketing initiatives, the discontinuation of key projects and a demoralized workforce. This constriction of operations initiates a downward spiral, impairing both your growth prospects and the morale of your team.
 

Funding Freeze

As the talent drains and the luster fades, raising capital becomes a Herculean task. Once-eager investors now become reluctant or completely disappear from the picture, fearing further losses in a venture that’s lost its sheen.
 

Reduced Growth

With key players gone and the cash coffers drying up, what follows is a reduction in growth, a forced frugality that impacts everything from product development to marketing efforts.
 

Market Perception Shift

The startup’s once-vibrant growth narrative dims, making it unattractive to venture capitalists seeking the next big exit. The resulting cutback in VC funding intensifies the downward spiral.

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Turning the Tide

Despite the gloom, there’s a path forward. The first step is recognizing that capital isn’t just about growth; it's about survival. Securing funding when the sun shines ensures you have an umbrella when it rains. 
 

Operational Prudence

The pivot to survival begins with a hard look at your operations. Focus on reaching breakeven and trim any initiatives that don't contribute directly to this goal. Swiftly pivot towards sustainability. Survival must precede growth.
 

Core Focus

Double down on what your startup does best. Channel resources towards your flagship products or services, with the goal of achieving positive cash flow to reduce dependency on external financing. At its core, your startup must do what it does best. It’s about doing more with less, being resourceful and efficient, and proving that your vision can withstand the trials of market fluctuations.
 

Employee Retention

Your team is your most valuable asset. Ensure they have compelling reasons to stay, aligned with the survival and eventual revival of your venture. Devise incentive schemes that motivate your core team to weather the storm alongside you. As the saying goes, “100 percent of nothing is nothing.” If you have to give up substantial equity to your top producers to ensure survival with employees who “think like an owner,” then do it.
 

Capital Conservation

In hindsight, the adage “raise when you can, not when you need” has never been more pertinent. Unfortunately, that ship has sailed for most, and the opportunity for preemptive action has passed. However, it’s not too late to adopt a more cautious and discerning approach to managing your remaining cash. This requires a thorough evaluation to ensure that cash is spent only where it will have a tangible impact on maintaining ongoing operations of the business.
 

Investor Engagement

Engaging effectively with your investors is imperative. Being transparent and providing attractive terms can transform your existing investors into powerful allies in challenging periods. It’s essential to initiate open and honest conversations with your investors early on. Explain the problems, your needs, and most importantly, how you will use their capital to solve the problems at hand and earn them a healthy return. Propose appealing terms to gain their ongoing support in optimally rightsizing and recapitalizing the business.

Next month, I’ll share 10 no-cost strategies to immediately boost your fundraising efforts. Until then, remember, the startup journey is a marathon, not a sprint. The death spiral is daunting, but with the right moves, you can navigate through these challenging times and emerge stronger. Stay resilient!