Hell or high water

A memo for founders on our 2023 market outlook

This week, as we begin to close out the year, we at Cherry Ventures shared new market guidance with all of our portfolio founders detailing our key takeaways and outlook for 2023. Today, we are sharing our portfolio memo more widely in hopes that all founders, operators, and investors — not just tied to the Cherry portfolio — will benefit.

You’ll see below that we don’t sugarcoat things. We’re still amidst one of the most challenging macroeconomic environments in recent history and, unfortunately, we forecast that it is not going to get any easier in the upcoming months. In fact, quite the contrary.

This is a difficult environment and will only get more difficult. But, at the same time, we also just want to say that, come hell or high water, we’re determined to face this market head-on.

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Dear founders,

As the year ends, we wanted to update you on what we have observed in the markets over the last few months and what we at Cherry believe may be in store in 2023. All of this, we hope, is to help you as entrepreneurs and business leaders navigate what continues to be one of the most challenging macroeconomic environments we have all experienced in a long time.

As we anticipated back in May, public market turmoil has continued to weigh on private financing rounds. Later-stage valuations have been the most impacted, with investors clearly taking their cue from the sell-offs experienced by publicly-listed peers. And, at all funding stages, we have seen a slowdown in VCs deploying capital relative to the all-time highs of 2021 (total invested capital and number of investments both down, although levels still above those in 2020), despite continued large sums of dry powder. Simultaneously, European tech layoffs, which began in Q2, have picked up speed and have since become widespread across sectors as various companies cut costs, prolong cash runway, and prepare for challenges ahead.

What we’re seeing

Public markets have re-priced dramatically

Public valuations continued to compress significantly on the back of higher rates and ongoing macroeconomic and geopolitical uncertainty. Predictably, growth and tech stocks have suffered the most in this environment as investors rotate out of positions that rely heavily on back-loaded value coming from profitability that could still be years away (GS Non-Profitable Tech Basket down -75% from Feb-21 high and down -60% YTD vs S&P approximately flat since Feb-21 and down -20% YTD). At the same time, higher rates have also made cash burn much more expensive to finance, adding yet more pressure on companies to prioritize profitability over growth.

Venture round activity has been slowing, although with a time lag versus public markets

Although financing rounds are still being led by reputable investors, we are seeing that it takes longer for these rounds to close and there have been examples of high-quality teams with strong performance finding it more challenging than usual to secure a lead investor for their follow-on round. In Q3, 60 Series C and 29 Series D+ deals were closed in Europe, down 35% and 52% YoY respectively, and the downward trend has accelerated further in Q4, with the number of Series C and D+ deals closed tracking at 49% and 67% below the respective equivalent periods last year.

Late-stage valuations are adjusting significantly and unicorn birth rates are slowing

Although the decline in public equities since the start of the year has dissuaded many large private European tech companies from coming to market, a handful of later-stage businesses have raised at significantly lower valuations, including the high-profile case of Klarna ($800M at $6.7B valuation, down 85% from $45.6B valuation secured in Jun-21). In a sign of down-rounds to come, others have chosen to cut valuations internally to reprice employee options, such as Checkout.com (down more than 70% to $11B from $40B) and Stripe (down 28% from its Mar-21 high of $95B). Evidence of the effect on early-stage companies began to show in the second half of the year and we expect to see more and more such cases in 2023.

Later-stage companies (Series C+) will continue to face a tough fundraising environment throughout next year (and likely beyond) with meaningful pressure on valuations. For these businesses, investors are and will be less open to accepting (i) high burn rates that have become more expensive to finance with rising rates and (ii) all of the profitability back-loaded many years in the future. Through Q3 2022, the proportion of down rounds increased from 2021 levels and reached 17%.

What we’re expecting

In spite of these challenges, there is a silver lining. In the long term, we expect the venture market to recover from this crisis much faster than it did after previous economic dips, such as the dot-com bubble in the early 2000s. The ecosystem has since matured and is now able to recycle capital and talent faster than before, supported by $2.5 trillion of dry powder globally, 8.5x the amount in 2000. The supply of innovative new companies is much greater and the rate of new company formation is less tied to public markets. Additionally, the venture market benefits from technology adoption rates that are much higher than what we saw a couple of decades ago (for example, ChatGPT crossed 1 million users in 5 days). Nevertheless, returning to the short term, we are still early in the downturn, some way from this recovery, and we expect a tough year ahead in 2023.

Our outlook for 2023

• Things are going to become even tougher in 2023. The past half year has shown how capital markets and asset prices are directly impacted by rising rates, but the pain in the real economy can take longer to play out. For businesses and consumers, the worst is yet to come. A recession will hit everyone and we are seeing the first signs of this already in the portfolio. Companies providing premium and discretionary services should see their KPIs come under pressure as consumers become increasingly squeezed. Similarly, B2B companies will be weighed down as customers scale back budgets and rationalize spend. H1 2022 largely escaped the worst of these challenges and we expect next year to be materially more difficult for the vast majority of private tech companies.
• Public market precedents will increasingly influence private valuations. Many private valuations are now far removed from the reality of market prices. Those companies that raised funding in or before Q1 2022 in particular will feel growing pressure on their valuations in 2023, and the gap to public prices will tighten.
• Beware of false dawns. Once inflation does start to fall, likely at some point later next year and led by the US after the Fed’s drastic interest rate increases, there may be sporadic relief driving rebounds to some growth tech stocks. However, we do not think these rebounds will mark a structural return to 2021 pricing levels as the cost of capital will remain higher overall and investors will continue to focus on profitability.
• Think ahead and prepare for success. Constantly review and challenge your cost base with the goal of retaining maximum optionality to raise future financing. Allow yourselves sufficient time to grow into the right set of KPIs for the following round.
• Embrace opportunities that the market presents. Use this time to make your business leaner and quicker to adapt to changes. Build for resilience. Customer acquisition costs might ultimately become cheaper and the hiring market will get easier to compete in compared with last year’s. Layoffs and employee stock options that are out of the money from large tech players will drive down opportunity costs to exit a job.

We also have another prediction. Not so much about what will happen in 2023, but what 2023 will create in the long term. 2023 — characterized by this tough market and the macro environment — will shape a generation of founders, who take the necessary steps today, to be more robust, more strategic, more determined, and more resilient than ever before. We are optimistic about how you, our founders, will lead in these times and we are excited to welcome many more like you into the portfolio in the future.