The top 20 tech billionaires globally have lost $480 billion on paper in the past year. Mark Zuckerberg lost a staggering $87 billion, Elon Musk and Jeff Bezos by $58 billion and the list goes on. This is largely due to several major stock market crashes and global economic uncertainties. But it’s not just billionaires who are struggling. It’s a tough time for a lot of startup founders right now. Many companies are now having to resort to tough measures in order to stay afloat, including layoffs, down rounds and tough terms from current investors.
This is not meant to be a negative post, but rather a temperature check of today’s market environment and the levers founders can pull on to survive this period.
Funding crunch intensified in Q3 2022
The major VC pullback continued despite record dry powder. But don’t count on the floodgates of VC funding opening suddenly in Q4 2022 or Q1 2023. It’s more likely that funds will decrease the pace of investments to last longer and a lot of that funding might be allocated for follow ons. As Micah Rosenbloom explains in HBR:
Tough times put investors into triage mode. Mature startups with proven business models and the potential to reach the public markets within a few years will be the safest place to park any new venture capital that comes into the ecosystem. The pressure to protect portfolio startups seen as potential fund returners will be profound.
Beyond that fortunate group, the funding situation will be less secure. The market for pre-seed and seed rounds should remain relatively active, since those companies are many years away from even thinking about going public. But even in the seed market the bar could get higher: I wouldn’t be surprised to see valuations drop and for VCs to have rising expectations about the level of traction they expect to see before funding.
Startups, Don’t Pin Your Hopes on VC Dry Powder (Source)
North American Venture investments totalled $39.7 billion in Q3 2022, down 53% year over year (YoY). The figure is below the heights of 2021 and early 2022 but above historical averages—representing a durable, positive trend in the industry.
Europe faced a similar fate and funding for the third quarter in Europe totalled $16 billion, down 44% year over year from $28 billion
And finally Israel, the market I cover primarily with Remagine Ventures, was also down 36%, resembling the 2020 levels. As IVC reports:
In Q1–Q3/2022, Israeli high-tech companies raised $12.3 billion in 538 deals. In Q3/2022, $2.6 billion were raised in 143 deals. The numbers for the first nine months of 2022 show the extent of the slowdown in almost all parts of the Israeli tech economy, except in early-stage. In the first nine months of 2022, Israeli Tech companies raised $12.3b, 30% less than in Q1–Q3/2021, but still the 2nd largest amount ever in this period.
Israeli tech review Q3 2022, IVC Online and Bank Leumi
It’s an investors market
Two weeks ago in San Francisco, a conversation with tech lawyers from the US and Europe was a confirmation of what I read in the news. Investors are calling the shots. Growth investors seek bargains and many shifted their focus to earlier stage. Tiger, Softbank and other crossover funds are slowing down significantly and valuations overall are down significantly. The later the stage, the bigger the impact.
Understanding the VC’s point of view
Investors are trying to protect their downside. On the one hand, the prices have come down as a result of the public market multiples, resulting in some funds investing in public equities as they see it as an opportunity to buy low.
Venture-capital firms are jumping into the stock market, buying up battered shares in publicly traded tech companies at a time when they are investing less in the startups that have long been their focus.
Some major venture firms including Accel and Lightspeed Venture Partners have purchased more stocks of companies they first backed as startups this year, defying the industry norm of selling those shares soon after public listings.
Venture-Capital Firms Buy Up Public Tech Stocks as Startup Market Stalls (Source: WSJ)
In a recent episode of All In, one of my favourite podcasts, Brad Gerstner, the co-founder of Altimeter capital showed historical industry data comparing the top quartile venture performance on TVPI and DPI.
- TVPI = total value to paid in capital (paper gains)
- DPI = distributed to paid-in capital (real cash gains, paid out)
The grey lines (TVPI) have never been higher relative to blue lines (DPI). The Orange line represents a 2x DPI average (most funds target a min of 3x). What’s evident is that we are about to see $500 billion in potential markdowns (i.e. portfolio values on paper that will likely be marked down and not be returned. Disclaimer is that this is of course an average of the top 25% and much of the asset class returns are concentrated in the anomalies, not the average. Generally speaking, emerging managers who invest early stage, are potential hedge for this as they’re less correlated with the public market, according to Cambridge Associates.
What is a founder to do?
Companies facing the possibility of a down round need to ask themselves if the reduction in their potential exit from a down round is worth having the cash in hand that investors are offering. If the answer is yes, then a down round is likely the best path forward.
Why you shouldn’t worry about raising a down round (source)
Tougher times might be coming ahead. While rounds are still getting done, investors are being more picky, reducing the speed of deployment and increasing their diligence and price sensitivity. For founders that don’t have product market fit or are close to profitability, it might be a tough market to raise capital in. That said, rounds are still getting done every day, and nothing is permanent.
- Down rounds – As Israeli media reports, down rounds have increased by 50%. They still represent the minority of rounds (90% of rounds are still up or flat). A down round might be tough to swallow, but if it gives the company the necessary cash to survive this period, the startup may still emerge victorious.
- Liquidation preferences – in addition to lower valuations, investors are looking for protective provisions. That means that in these down rounds, some investors are asking to 2-5x liquidation preferences. That means that investors are contractually demanding to get 2-5x their investment, before other share classes get paid.
- Venture Debt – In Q2 2022, US startups borrowed $9.7 billion in venture debt, the second-highest quarter on record. But in the third quarter, venture debt deal value fell by half to $4.7 billion, the lowest quarterly volume since Q3 2017, according to the latest PitchBook-NVCA Venture Monitor. The reason is that as interest rates increase, the debt becomes costly capital to return.
- CVCs – So far, corporate venture capital investors remained very active in 2022. CVCs have participated in 25.6% of VC deal count and 45.1% of deal value. That said, other non-traditional investors Except for corporate venture capital investor types have fallen faster than the broader venture market in 2022.
- M&A – In the US, exits are down almost 50% against historical norms, with public listings at record lows according to the Q3 2022 NVCA Venture Monitor. In Q3 302 exit events took place, amounting to $14.0 billion in exit value with few bright spots to speak of. The pricing is a derivative of public markets multiples, which means that when exits happen they are likely to be moderately priced.
Seed and Angel remains positive
Seed and pre-seed have stayed more resilient despite the macro level decline in activity, however, Q3 2022 saw an 18% decline from the Q1 high, dropping angel & seed deal activity back to 2020 levels.
The advice for founders remains similar to what I recommended back in May 2022 in my post on advice for founders in a downturn. Reduce burn, keep on shipping and focus on sales efficiency. Keep your head up! Things will get better.