Why Investors are Focused on Efficiency

Founders Likely Feeling Whiplash from 2021 to 2022/23

Jan 03, 2023

The time value of money has increased is the simple explanation.

Let’s dive a bit more into what that means.

This is why suddenly our money market accounts are actually giving us interest payments again

From the chart above, you can see the 1-year Treasury Bill has gone from 0.38% at the start of the year to 4.5% at the end of 2022. Why does this matter to the time value of money? Well, as an investor you can now earn a risk-free return of 4.5% on cash where before you were effectively earning 0%. So relative to early 2022, the value of money back in someone’s hands is 4% higher than it was.

Now add in the component of risk. In order to justify a new investment, an investor needs to be compensated for the risk. How do you quantify risk? Well it’s a function of 1) the probability of permanent capital loss, 2) the time it’ll take to get that money back, and 3) the potential reinvestment opportunities that capital has. This is a major reason why in 2022 while rates went up 4%, cloud computing stocks got cut in half. Since these companies are mostly still far away from returning cash flow back to investors, the market demanded a higher future forward return to own the stocks. So the prices need to go down in order to match that expected return. Not to mention the extended valuations that many of these stocks were trading at anyway regardless of where rates where.

The cloud computing ETF was down 52.5% in 2022

The other interesting aspect of major changes like this is not just the prices that investors are willing to pay and the higher potential return they demand, but also timeframes. During period like this timeframes shorten. Investors naturally want money back quicker to redeploy into higher earning assets. But also, everyone is watching risk more closely. For startups, this is why so many boards are focused on maintaining at least 2 years of runway and doing scenario planning. Yes, everyone still wants to build a sustainable business for the long term, but you can’t get there if the business runs out of cash and dies first.

Hence, this leads to the situation that startups are in. Investors are favoring efficiency over growth. If a company can grow 200% YoY but will burn 2x the amount of money to get there, that company is actually more at risk of securing funding for the next round then if they grew 100% YoY and burned the lesser amount.

For founders of course, that’s all well and good but a very tough change to make. In many cases, this requires layoffs of great people that the entire company has built relationships with, cutting back on new products planned, pulling back on expansion plans, and reprioritizing the product roadmap. The “less is more” adage starts to rise in prevalence again.

The amazing part is that for those companies that are proactive and steer the company to the other side, there are less competitors, still the same customer pain points to solve, and a battle-tested team ready to take market share as the fog starts to clear.

What I enjoyed this week: