While last year was a record-breaker in terms of venture capital doled out to startups, this year is trending to be a much different story.
Geopolitical tensions, inflation, expected interest rate hikes, and a seemingly never-ending pandemic are starting to affect the private markets, venture capitalists say.
While the effects on the public market are obvious—the Dow Jones Industrial Average is down about 7.5 percent and the Nasdaq Composite, a good indicator of tech prices, is down about 13.5 percent since the start of the year—getting a gauge on the private markets is more difficult. However, those in the industry say although deals are being made, valuations are coming off the highs of last year, and some companies are reevaluating their fundraising efforts.
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“If you are a special company, you are still getting the valuation you want,” said Mark Sherman, managing director at Telstra Ventures. “But I would say the more ‘meat and potato’ companies are probably down 20 percent in January-February in relation to November-December—some more, some less.”
Not off a cliff
Despite the cuts—and reports of large firms like Tiger Global and D1 Capital pulling back on late-stage investments—fundraising is by no means dead, VCs say. Companies that are growing at 3x or more are having no problem raising cash, however others are having more difficulty. While the problem is most pronounced in later growth rounds, it also has moved into earlier Series As and Bs.
“In Q3-Q4 (of last year) companies imagined it would take weeks,” Sherman said. “Now it will take months. Back then there was a formula and all things were a go. But companies are still getting term sheets.”
However, some are surprised at the pace at which the public market tumult seems to have crept into the private markets. While January remained strong for fundraising, the last few days of February seemed to show decreasing deal flow and size, according to Crunchbase data.
“I think the market pullback is here,” said Ryan Bloomer, founder and managing partner at K50 Ventures. “I think what we saw happen in the public market is leading the private to a big dose of reality.”
Don Butler is managing director at Thomvest Ventures and has been in venture for more than two decades. Historically, there has always been a longer lag in the private market’s reaction to a public market slowdown, he said. In 2008-09, it took the private markets about six to nine months to react to what happened on Wall Street, he said.
“I wish I could tell you why this happened faster,” he said. “I think part of it is that the stakes have been raised. Investors see real inflation could happen. Does the Ukraine (issue) mean even more inflation because of commodity pricing due to fuel costs? Could that lead to a recession?”
The COVID effect
Then there is the topic that never goes away—COVID-19. Consumer behavior during the pandemic seems to have played a role in the public market—and private investors may be taking note.
“There was a narrative COVID accelerated everything five years forward,” said Butler, pointing to the gains shown by companies including Peloton and Netflix during the pandemic, just to have disappointing numbers in recent earnings.
“This is just a theory, but we thought the market moved forward and now (those companies) are churning customers,” Butler said. “Maybe consumer behavior—which changes very organically—didn’t change as much as we thought.”
Investors also seem to believe this current time is different from March 2020, which saw a slowdown in venture for about two months as much of the U.S. sheltered in place. Many startups and VCs used that time to reevaluate their plans and figure out ways to get to cash-flow neutral if a worst-case scenario played out.
“In March 2020 everyone was looking around the room and figuring out what was happening,” said Jordan Nof, co-founder and managing partner at Tusk Venture Partners. “No one really understood what was going on.
“That was an anomaly; this is more of an economic cycle,” said Nof, pointing to inflation, housing prices, correction in valuations and, to some extent, geopolitical issues.
What happens next?
Many VCs, who are by nature eternal optimists, are quick to point out that some sectors have maintained—or should—a relatively unaffected pace of investment. Industries like blockchain, crypto, climate tech and cybersecurity—which was called by one investor “the Energizer bunny” of fundraising—all continue to see interest from investors.
“There are two types of companies that need to be careful: ones that are all tech and no revenue, or all revenue but no tech,” Bloomer said. “You have to be solving real problems for real people.”
Companies that find the market less than enticing right now also could pull different financial levers, investors say. Obviously the first would be to get to cash-flow neutral—which is not an option for many startups.
Another would be to wait on raising, especially since startups were successful in fundraising in the last year or so when times were good.
“I’ve seen this merry-go-round before, it doesn’t go on forever,” said John Chambers, chairman emeritus of Cisco and founder and CEO of Palo Alto’s JC2 Ventures. Chambers said about 75 percent of his portfolio companies raised money in the last year, giving them runway now that the market has hit some craters.
“Cash is always king,” he said.
Chambers offered a reminder that downturns also provide opportunity to companies. Market share can be hard to get when times are good and competition fierce, but more easily gained when there is a downturn if the company is well-positioned.
“Cisco did this, Amazon did this,” said Chambers. Being nimble and flexible will be key for startups, he added.
“Like my parents always said, ‘You have to deal with the way it is, not the way you wish it was,’” he said.
New ways to raise capital
There also are different ways to raise cash.
Butler said he has seen an increase in convertible notes in the market. Such notes allow a company to get money—typically from a desired strategic or VC firm—now, while said investor gets a discount when the company raises its next round.
“How much valuations have dropped is hard to say, because I think some companies are kicking that can down the road, including with convertible notes,” Butler said. “So we may not really have an answer until Q2 or Q3.”
What those quarters will hold is anybody’s guess, but most seem to believe it will be a refocusing on value and not just growth—which may not be a bad thing for the market.
“I don’t think this is all doom and gloom,” Bloomer said. “Investors and founders need to answer, ‘have you found a product market fit?’ We have to get back to first-principle investing.”
Illustration: Li-Anne Dias.
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