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Zero interest-rate babies are facing their day of reckoning. It’s time this generation of startups learns how to fly

February 7, 2024
in Business
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Zero interest-rate babies are facing their day of reckoning. It’s time this generation of startups learns how to fly
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Zero interest-rate babies are facing their day of reckoning. It’s time this generation of startups learns how to fly

A decade of low interest rates and cheap capital birthed a startup generation of “zero interest-rate babies.” Now that rising interest rates have turned public markets sour on disruptive, high-growth tech companies, investors are pushing these ZIRBs out of the nest.

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In 2024, they must learn how to fly before they hit the ground. The stakes are not limited to these companies. The value of high-growth, disruptive tech companies is equivalent to about 7.3% of the U.S. gross domestic product. There are more than 1,200 unicorns with billion-dollar-plus valuations in the world, according to Pitchbook data. More than half of these (approximately 600) are based in the U.S. Not far behind is an army of soon-to-be unicorns, valued at more than $500 million.

Even as changing market conditions reveal many of their weak spots, most of these companies have so far been immune to public scrutiny. But these ZIRBs share a troubling trait: they were able to hide severe structural flaws beneath enthusiastic but unsustainable growth conditions.

To learn how to really fly, ZIRB CEOs, CFOs, and investors need to throw out traditional backward-looking financial analyses and build confidence in the solidity of the company’s economic engine and subsequent paths to growth and profitability. These paths should be clear, well-framed, and consistent with the company’s end goal in terms of financing options. The following fundamental questions can help establish the feasibility of these paths:

What is the quality of the company’s revenue?

The key element to look for here is the truly “recurring” nature of the business, including a critical analysis of what is behind Annual Recurring Revenue (ARR). In the case of non-software businesses, this means understanding how much revenue is re-occurring and making sure that high margins are associated with this revenue stream. Quality of revenue also refers to customer base quality and diversification as well as the strength of the user or customer’s own economics.

What is the quality of the company’s growth?

It is critical to confirm that growth has a solid foundation, grounded on the existing customer base. For SaaS businesses, this is best measured through net revenue retention (NRR, the percentage of revenue now received from a customer compared to a year ago, taking into account expansion) and gross revenue retention (GRR, the percentage of revenue from a customer that remains after one year). Once a decision is made on the quality of growth for existing customers, it will be key to assess the company’s ability to fuel the new business engine efficiently.

In marketplace businesses, quality of growth can be reflected in the ability to increase the take rate. For example, Uber’s take rate has risen (29% in 2023 vs. 19% in 2021) as the company improved its value proposition.

What is the quality of the company’s margins?

With the end of subsidized growth, only strong gross (or contribution) margins can support a sustainable cost structure that also requires innovation and investment in research and development to remain competitive. At a cash-flow level, strong operating margins are needed to drive growth at scale for these businesses.

How resilient is the company?

Once a decision is made on the path to growth and profitability, ZIRBs will also need to be assessed through the lens of their resilience. If financial controls are reviewed as a part of legal audits, governance stands out as perhaps the most critical point here because it can lack a clear framework and should be assessed deeply.

This must include guardrails to ensure founders don’t cross the line between high confidence and self-belief, which are key to building true industry leaders, and exaggeration–or even fraud. As these companies continue to build our future and transform our societies, their resilience also rests on their ability to comply with essential environmental, social, and governance (ESG) criteria, notably climate and diversity, equity, and inclusion (DEI) considerations.

Only by answering these questions can investors accurately assess the prospects and viability of a high-growth tech company. Many CEOs and investors will discover weaknesses within the ZIRB universe over the coming months, resulting in some high-profile failures.

The good news is that there’s still time for most of these babies to course-correct by adapting to the new capital paradigm and raising the probability of reaching a healthy adulthood.

Raphaelle d’Ornano is the CEO of strategic consultancy D’Ornano+Co.

More must-read commentary published by Fortune:

The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.

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