Are we witnessing a major VC pullback? Is it temporary? What does that mean for startups? Certainly the topic du jour in startup circles.
Here’s what I’m seeing.
IS THE PULLBACK REAL?
Yes. The market is a bit all over the place, not everyone fully agrees on what’s happening, and certainly a number of financings are still taking place. But the pullback is real and already starting to show in the data (CB Insights Q1’22 report).
My sense is that the current reality of the market is a lot worse, because deal data is a trailing indicator – financings are often announced months after they closed.
We’ve rapidly, perhaps brutally, transitioned from a hyper frothy VC environment to a world where many deals are not getting done.
As tends to be the case, the correction started happening in public markets (sometime in H2 2021), then propagated down to the private venture growth market (Q1 2022), then to the Series A/B stage (currently). Venture tends to work as an assembly line, with each investor depending on the next stage (either a next round of financing or a public company IPO exit) for their short term success. As the next stage becomes trickier, the natural inclination is to slow down activity to avoid having more investments slam into a wall. It takes a few months for that cycle to happen, and for a bear market to trickle down from post-IPO to seed.
In a lot of conversations with VC friends, I’m told people have hardly made any net new investment in 2022. The growth market seems effectively dead right now. Tiger, after a very intense couple of years at the growth stage, seems to have moved overnight to seed/Series A. The two firms I’m seeing consistently active at the growth stage right now are Insight and Softbank.
Only two parts of the market have been spared so far:
- seed: plenty of financings still happening at the seed level. No real compression on valuations yet. YC is as frothy as ever. Arguably, the seed stage should be the most recession-proof area of venture, because seed companies are 6-10 years away from a meaningful exit, and no one can predict where the market will be then. Also, checks are smaller, especially seen from the perspective of the very large multi-stage firms that have earmarked hundreds of millions of dollars to seed the seed stage.
- crypto: the web3 market largely follows its own logic. Many investments are token based, rather than equity based, so to some extent web3 companies a less immediately caught in the propagation logic mentioned above. Also, market traction can be somewhat circular and self-reinforcing in the web3 world, as companies and projects tend to be closely intertwined. Finally, after an explosion of crypto VC funds, there’s arguably a lot more money chasing deals, than truly exciting companies and projects just yet.
It also seems that the pullback is mostly a US phenomenon right now. From all my conversations with European friends, for example, things continue to be frothy over there. My sense is that the current US situation will propagate internationally sooner rather than later.
Wait, but haven’t VCs raised huge funds? Doesn’t that money need to go somewhere?
Yes, VCs have raised funds at an unprecedented pace in 2020-2021. And yes, with some nuances, there are economic incentives for them to deploy the funds (management fees on called capital, different variations there depending on LP agreements).
So, where is that money going to go?
First, and to rule it out (hopefully) – there’s a disaster scenario where the broad market enters into deep recession and LPs get out of / renege on commitments. Remember, when a VC fund closes a new fund, capital is not provided as of Day 1 but instead gets called from LPs over several years, as the fund makes investments.
Second, in a world where the next round doesn’t happen magically every few months, VCs are likely to need to use more capital to support their existing portfolio, as opposed to making net new investments. For the last couple of years, inside rounds had become a sign of strength as investors wanted to pile more money into winners. Expect a reversal to the historical norm where inside rounds are mostly used to support portfolio companies that are getting short on cash.
Third, the market is going to become ever more bifurcated than it’s been. For the last few years, it’s been tale of “haves and have nots”, where money tends to concentrate in comparatively fewer companies, the well-discussed “flight to quality”. This is only going to accelerate from here, with the companies perceived as “best” attracting the lion share of new capital. One rationale will be that, in a slowing market, those companies will have an opportunity to acquire weaker competitors and become industry consolidators.
Fourth, and perhaps most importantly, expect slower fund deployment times. The last couple of years have seen a lot of VCs raise a fund, promise their LPs a 2 or 3 deployment timeline, only to come back 18 months later raising a much bigger fund. As LP patience (and resources) got seriously tested, expect VCs to give their investor base a rest and deploy current funds at much slower pace.
HOW LONG IS THIS GOING TO LAST?
I want to believe that there’s an optimistic version where this is a short term correction. It is somewhat ironic that many growth startups and public tech companies are crushing it in terms of overall business performance, but still getting hammered by investors.
Equally, there’s a little bit of “what goes up must come down” and we’re just coming out of one of the longest bull runs in history. Yes, software will continue to eat the world, but in the short term, our ecosystem of startups and venture capital is still a tiny part of the world economy. Macro changes like interest rate hikes move trillions of dollars, and we’re just a trickle in that overall flood.
One key condition to VC activity re-accelerating: the market needs to stabilize to a new normal.
No VC wants to do “a 2022 deal at a 2021 valuation”, but what is a 2022 deal exactly?
We’ve certainly come down from the 100x-200x ARR craziness but there’s still the odd financing round that gets done at those levels. Founder expectations are all over the place, with many still living in the 2020-2021 valuation world — for perfectly legitimate reasons since they generally only step a toe in the financing world every few months or years, as opposed to VCs who live in it every day. The general perception amongst VCs is that deals are still very expensive.
One variable that seems to be changing is round size expectations, perhaps as a precursor to lower valuations. From what I’m seeing, the inflation there has slowed down considerably. Over the last couple of years, Series A rounds had ballooned from $12M-$15M to $20M. It seems that the $20M Series A has largely disappeared, and I’m seeing asks back down to $10M-$15M.
WHAT SHOULD FOUNDERS DO?
That’s the obvious question everyone is currently discussing.
The easy (to say) part: at a minimum, be increasingly careful with cash. A number of companies in the FirstMark portfolio have gone through reforecasting, revisiting budget and burn projections. I’m not suggesting everyone should run for the hills and go in cockroach mode – some emerging leaders will want to remain aggressive in conquering their markets. But we’re certainly entering an era of tighter financial management, at a minimum.
The hardest question is whether startups should rush to the financing market now and get a round done before things get too bad. That’s highly case specific, and I’m not going to venture to provide a general answer to this here. But if you’re getting to 12 months of cash runway or less, it might make sense to do this sooner rather than later. At a minimum, financing processes are taking much longer than they did in the last couple of years.
WHERE DOES THAT LEAVE THE STARTUP ECOSYSTEM?
A positive way to think about the current situation is that it is healthy and overdue evolution for the ecosystem.
Ultimately, it’s not good for anyone, including very much founders, to be stretched to the extreme limits of expectations and be in a situation where over-performance becomes the base case.
It’s also healthy for everyone to come back to a world where everyone has a bit more time to make thoughtful decisions. We had certainly hit a “greed on”, “YOLO” phase, with a “Fire, Ready, Aim” mentality where deal velocity was paramount, and very little time to do actual due diligence as a result.
This was very 2021:
Many in the ecosystem welcome a slowdown in pace, with the opportunity for more meaningful work and deeper relationships.
What happens next? Nobody can predict the future (certainly not me), but should a prolonged VC pullback indeed happen, it’s interesting to think through what that may mean for our startup/venture ecosystem.
One open question: a great aspect of the VC financing frenzy of the last few years is that investors (and founders) got increasingly experimental and willing to fund ventures in deep tech for example (really cool companies in space tech, synthetic bio, energy etc), and also in non-traditional geographies. Just like emerging neighborhoods get hit first when the housing market turns, will those be disproportionally affected?
Another potential open question: as VC financing becomes harder to get, will the number and quality of startups decrease? Encouraged by a frothy environment, many in recent years left their high-paying jobs in big tech companies to start their own ventures (one example being the many engineers who started open source projects at places like Airbnb, Facebook, LinkedIn and Neflix and left to start commercial companies based on those projects). This created a virtuous circle and a very exciting flow of top quality founders companies. Will it now turn into a vicious circle?
It is well known that some of the best startups are created in down cycles, but it takes an extra special founder to want to venture out in a difficult environment.
One final open question: what does this mean for the venture capital industry? Certainly VC had experienced unprecedented levels of evolution (or disruption) over the last couple of years – crossover funds, mega-funds, solo GPs, emerging DAOs in crypto. What happens to all of this, over the next few years?
My general sense is that we will see some level of reversion back to the original model. This tweet is a bit strongly worded but directionally what I mean:
Some concluding thoughts. I’m as bullish as ever on the gigantic opportunity ahead for startups. Also, this is not meant to be a “the world has come to an end” type post – financings are still getting done, just at a very different pace. I certainly hope this post does not age well, and looks silly in a year from now, as the market came back roaring. But if the current situation were to keep going or get worse, we’re going to collectively have to learn to navigate different times.