Public market valuations are dropping precipitously. Growth stage venture capital investors are in a state of panic. VC Twitter is awash with projections and predictions that things are going to be tough for a while. Sentiment feels increasingly negative.
For those who have known nothing but a never-ending bull market for their entire professional lives, this is an unsettling time. But the idea that the bull market would never end – despite what a large number of self-serving Twitterati may say – was always fanciful. Markets are inherently cyclical and periods of correction are inevitable.
For public market investors, the impact of downturns is felt almost immediately, but for the venture capital market, it takes longer to figure out the consequences. Any analysis is further complicated because venture capital is a loose term that covers rounds from a $500k pre-seed all the way up to multi-billion dollar growth cheques.
Growth investors are thus far most impacted by the current market conditions. This is because they are investing closer in time to an exit. Their business model relies on a vibrant IPO market and positive sentiment towards M&A to realize their investments.
Whilst most funds have the dry powder to ride out a period of illiquidity, supporting their portfolio with bridge financings, exuberant behavior in recent years has created more pressure on GPs in these funds. This is being felt most acutely by funds that invest in the latest stage rounds (Series D upwards) where the time to exit is shortest.
First, many funds have adopted compressed fundraising cycles, raising new funds every 12-18 months. This creates a small window to demonstrate performance to LPs, either through paper mark-ups or cash realizations. With the public markets having fallen, GPs will be trying to raise with portfolios that have taken significant markdowns and LPs are unlikely to be impressed. The entire model of writing large growth cheques and generating quick returns via public market listings may be over for now.
Second, the fierce level of competition between growth funds over the past few years means that rounds have often been significantly overvalued. At the time the investment was made, it may have been possible to find some relevant comps or other justification for paying such a high price, but in today’s revalued market this has compounded the problem for GPs. In some cases, they are holding shares in companies where the price they paid means they may never be able to realize a return.
Third, some investments made in the past few years feel a little too similar to those made in the late 1990s. They rely on both a never-ending supply of capital to power growth and only reach profitability at an enormous scale. It is likely in today’s market that these companies will be cut first as GPs look to protect their investments that have positive unit economics and are either profitable or stand a realistic chance of becoming so.
Series A Investors
For Series A investors, the picture is mixed. Multi-stage funds that do Series A may need to switch focus to protect their later-stage growth investments. For dedicated Series A funds, this is an opportunity to access the best deals that are now less contested.
Overall, sentiment at Series A remains positive but cautious. Investors know that the road to a successful growth round may take longer given the challenges for those funds at the moment. This caution is manifesting itself in two main ways.
First, round sizes have reduced – where a $15-20m Series A (or much more) may have been achievable in Europe in the last two years, $10-15 is more typical now. Arguably, this reflects a return to the long-term norm rather than a worrisome trend.
Second, investors are becoming more selective and there is a flight to quality. A successful Series A round now has all the components you would have expected to need a few years ago; revenues and revenue growth, a strong team, and a large market.
Early Stage Investors
For early-stage – pre-seed and seed investors – the impacts are similar to Series A with a focus on not overpaying for deals and on the highest quality opportunities. Since early-stage investors are used to having many years of uncertainty ahead of their companies, general sentiment follows the mantra to Keep Calm and Carry On.
Where early-stage investors have companies that are due to fundraise this year, a lot of work is going into making that process as strong as possible. Investors are also thinking strategically about the best options for the next round, with some opting for internal bridge or full seed plus rounds to position their founders well for Series A.
Overall, the picture across the different types of funds is mixed and the impact for individual funds varies enormously depending on how they have been operating in the past few years. Where discipline has weakened, rule books have been torn up and due diligence has been put to one side, there will be natural consequences from this behavior. On the flipside, where funds have been more measured, they are likely to fare better.
For founders, many have already weathered one of the most difficult periods in recent history by getting through the pandemic. Now is the time to front up to another challenge and adopt many of the same approaches to come out safely on the other side.