A few thoughts on the current market evolutions — Chapter 3

By Xavier Lazarus, with the help from Marc Rougier, Saish Rane, Justine Guers, Delphine Villuendas & Louisa Mesnard

Facing this new market condition, I gathered thoughts and analysis from both discussions with key players on both sides of the Atlantic and based on my past experience in times of crisis. Having started when some of my colleagues were still in Kindergarten, 20 years ago and 3 crises ago, is one of the few privileges I have in the market!

In these five chapters — published weekly on our Medium account, you’ll find a compilation of data, insights and advice I’d like to share and discuss with you. This is by no means a sure-fire thesis nor an omniscient crystal ball, rather the strong desire to share data and provoke thoughts, so we can collectively weather the unfolding stormy conditions.

You can find the two previous articles here: Chapter 1, Chapter 2

Valuations in VC will adapt to this new landscape without a doubt. Remember that the valuation of a business is the present value of the expected future cash flow of this business. Multiples (of earnings or EBIT or Revenues) are just an easy-to-use proxy of this definition, mostly reflecting the growth expectations of the company. If the future is darker or blurry, growth perspectives are lower, hence multiples will follow suit. We are not here facing a short-term offer/demand unbalance similar to March 2020 when the Nasdaq lost around 30% and regained them in only a few weeks. Valuation multiples should remain “lower” for a while. This could be painful for the founders’ short and medium term plans, their equity incentive plan attractiveness, and the mark-to-market valuations in the books of their backers. But there is no way to escape this repricing for most of the companies in the market.

One of the usual knockbacks that I receive on this opinion when I discuss with some colleagues and entrepreneurs is that current P&Ls and business metrics disagree with this prediction: Q1 numbers were between good and great and Q2 doesn’t look too dramatic — even if the recent Q2 earnings of ad related companies such as Snap, and the associated drama on the market are a strong foghorn warning us that we are getting closer to an iceberg. So, what could be happening here? To my mind, it is quite simple: investment budgets have not been reviewed yet and businesses are still open for investment. Remember, budgets were designed in 2021, under euphoria. Reforecasts will start this summer, and nothing will move before that. The expected final will be when 2022 H2 numbers and 2023 forecast will be known, as they will be based on adjusted market demand after the macroeconomics are digested. This can also explain why the capital markets will be quite volatile for a while: analysts and fund managers have a hard time believing current forecasts or analyzing recent numbers and will wait for the adaptation of the business plans of the listed companies to decide which ones to support and which ones not to.

What is even more worrying is that the usual trick from the states, public institutions and banks to sustain markets and the economy won’t work this time. Their historical move is to inject high levels of liquidity at a cheap cost. Call it bailing out, quantitative easing etc. This time, it will not happen. We are post-Covid, the state war chests are empty and fighting inflation prevents from maintaining low interest rates — not to mention the dramatic geopolitical context that adds to the global uncertainty. The US Fed has raised the interest rate by 75 basis points for the second time in a row in order to combat inflation which is quite the opposite of what happened during Covid when they lowered interest rates to near zero to sustain the economy. The same is true in Europe where, on the very same day, the European Central Bank raised interest rates for the first time in 11 years.

Another argument against the VC market correction, is the unseen level of dry powder in VC funds, providing a strong demand which will sustain market prices. My take here is that this phenomenon, however real it may be, could only provide a short-term illusion of sustainability. Here is why:

When we discuss companies financing, money looks like a fluid, flowing from one bucket to another through pipelines, each of the buckets being a stage of financing, with a “final” bucket being the exit. Usual exit for a VC is by listing the company or selling it to either a Private Equity or a strategic acquirer. In this simplified analogy, valuations would be a special kind of measure of this flow when you move from one bucket to another — maybe the diameter of the pipe would be the best proxy for valuation.

Currently, the tank which supplies the system is full, from seed stage to Private Equity. So, why don’t the pipelines remain wide open? The financial market shut down which means that the exit bucket is way smaller than before; the pipeline leading towards it is either closed for IPO or much narrower for M&A deals (most of the strategic acquirers are listed companies, paying with their own multiple in mind). The PE bucket is still heavily loaded so why wouldn’t they still be willing to slightly overpay for a while? They will and already are the first and strongest to adapt on M&A prices, as their investment thesis is always much more based on market comparables, profit margins and cash flows than other investors.

Debit will need to adjust to the fact that the last bucket is smaller and as a consequence, size of intermediary pipelines will reduce and valuations will adapt. Worse, the current macroeconomics makes me believe that there will be less water in the system eventually to re-up the tanks when emptied… Another reason why valuations will adapt also on the longer run and maybe big time, and that any dry powder effect is temporary and should not be misleading.

By the way, recent Crunchbase numbers for France are clear as day: the flow of money cutback has started, VC funding in Q2 2022 is 27% lower than in Q1. But we are still above any quarter prior to 2021, because the tanks are still quite overloaded. Correction has started but is far from being over.

France posted a record Q2 2022 funding amount of €3.2 billion (source: Dealroom.co) which propelled it to the leading position among EU tech ecosystems. We are glad to be part of a thriving ecosystem but this data needs to be taken with caution and a well-known point arises again: is this a French tech revolution or just a lag in getting up to speed with the global ecosystem?

We should prepare ourselves, our entrepreneurs and our investors for that phenomenon. Is it bad for the ecosystem? Not really for the ones who can adapt but it can be a real drama for players which have built fund strategies, growth plans or asset allocations that rely, in order to perform or even to survive, on a world that works like in 2021.

The main consequences our ecosystem will have to face and should prepare for are:

1. Dilutions will go up.

We have been at a very low level for the last few years. We, early stage VCs, should be heading quickly back to 25 to 30% of ownership at each round. The peak of dilution which happened in the market in the two previous crises, was 40%+ so even at 25–30%, there will still be room for dilutions to go up. Is this good news for VCs? Should the early investors directly request these high levels of dilution now? We need to be careful, if a Seed or a Series A investor anticipates the market adaptation too much and takes a huge chunk of the capital for little money, the alignment of interests between future later stage investors and founding members is completely compromised and the company’s capacity to raise more equity further down the road might already have been killed after a couple of rounds. Dilutions will increase but the best VCs will not asphyxiate their entrepreneurs.

2. Rounds will be smaller.

To prevent dilution from being too punitive, entrepreneurs will mechanically raise less money. Consequently, companies will have to learn to do the same, if not more, with less. Nothing new for companies in sectors that are not historically well funded, such as many deep tech ones: they will just keep on hustling their way as usual. Some spoiled sectors, where money was available with no pain and huge gain, will have to go back to basics. With less money, we will need to be smarter or at least more creative.

There even might be large parts of the tech economy whose existence will be questioned per se. The ones with business models where viability was only possible via VC subsidizing for example (would anyone really be willing to pay the huge delivery cost for a pack of 6 eggs that you “need” at 2AM for a crêpe party?)

3. Competition between VCs will intensify and then reduce strongly.

With smaller rounds while VC funds are still loaded, syndication will be a more complex discussion now during a few quarters. Competition will still be intense for the best companies especially when founded by repeat entrepreneurs. This will first give some bargaining power to the best entrepreneurs to maintain prices, but when current funds will be invested and the size of their next generation will have adapted, syndication will be back in its usual manner and this temporary bargaining power will vanish. Competition between funds will evolve accordingly.

4. Funds size will stop climbing and may even reduce in some cases.

When competition between funds will diminish and companies’ funding rounds will stabilize to the right size at each stage, VCs and their investors will adapt and set the right level of investment size and pace, to deliver the optimal performance to size ratio. I don’t know the exact answer but for most of the VCs, it’s clearly below the inflated 2021 figures.

5. Not every company will be able to raise money.

At some point, money will be missing in the system and there will be more opportunities than cash in the market. Second tier startups will be the first ones to suffer from this and most of them will have a hard time to raise any money at all. If the crisis lasts too long, some good assets might fall too. And this really hurts.

6. Intermediate valuations will be much more reasonable.

The only important valuation in an entrepreneur’s or an investor’s journey is the one at which they will sell their shares of the company. The rest are only dilution rates, proof points of potential success, vanity metrics etc. These last years, they were exhibited by entrepreneurs or by VCs as lifetime achievements. This will be over, and people will understand that the real value lies ahead and is not crystallized by any single intermediate number.

7. Flat and down rounds will be back.

Entrepreneurs and investors should just acknowledge that valuations are not an ever-growing function and not put at risk their entire work for not having to downgrade a fund’s mark to market multiple or lose a unicorn status. We already see this on both sides of the ocean. Raising a flat or down round is not a drama. The only drama is to go bankrupt. In this case, everyone involved would have lost everything… If it is true that what doesn’t kill you makes you stronger, what did kill you, just killed you.

8. Some reckless investor strategies will be jeopardized.

Large secondaries in rounds, partial liquidity etc., will taper off to a point that they will become rarer than seeing an actual unicorn. Some of the solo VCs, startup studios, micro funds, and angels’ clubs whose strategy was to invest early with no follow-ons, pump the valuation to the maximum by organizing a belly dancing contest of later stage investors, and eventually escape with 5 to 10x multiple before the company has demonstrated much, should take a second look at their Excel models and start calling back their own investors.

9. Structured deals will be back.

Structuring means ratchets, participating preference clauses, sometimes even with a multiple, etc. To be fair, I always thought that these are effective tools to marginally adapt the cap table at exit when valuations are at risk. However, a serious issue lies in the uncontrolled stacking of these rights and the insane governance that might come as a consequence when structured layers are added round after round. I do believe that if valuations and round sizes adapt, and if there is no more “crime inducing” behavior in intermediate rounds where a huge part of the cash went in early backers’ pockets, we shouldn’t need to overplay this return of structuring, especially at early stage. But sometimes the market overcorrects the excess of the past with an excess in the other direction…

The message is clear here: anyone in the market will be better off on the buyers’ side of the table for a while. Luckily, buying into a so-so company at a low price will still be considered a bad idea in an early-stage venture, even if it won’t be as bad as buying into one at a high price. The market will not turn into a bottom feeding or thrift shopping game. I expect that this correction will be at different scales at a later stage (Series B or above), depending on the quality of the company and that the market will not behave in the same manner for every startup.

• The very best companies will suffer only a bit and will take more time and effort to reach their objectives, but they will eventually perform. The very best, if they are currently very well funded, shouldn’t even correct their current valuations and should easily attract more money and investors in good conditions, even if not as good as last year.
• The good companies which have raised recently a large late-stage round, will always be valued significantly enough (at least the ones with a positive business model), so if they spend their cash wisely, they could manage to go through and if they picked their lead investor correctly, they should receive support and even maybe some extra cash at a decent cost from their current syndicate to weather the crisis. Then they will be back on track, even if at a lower altitude.
• The “good but not so great” ones or the “good but with an urgent need of cash” ones, which are still in their early stages, will have a harder time to attract money on good terms. It may be wise to advise them to look for a plan B in parallel with their current execution.

What then could this plan B be for the latter?

In the US, it is quite hard to imagine any plan B that makes sense. Investors always play all-in, looking for the big game only. Entrepreneurs follow that trend to get their money so reducing speed is usually a definitively negative signal.

But in Europe, we historically lack “big game” options. We will not discuss why here; this has been debated for a while now and is already quite well documented (no single large market to start in, the kind of CVs of VCs, lack of money in the market, no Nasdaq or strong M&A to exit etc.). We will also not discuss the huge progress our European ecosystem has made on the topic over the last decade, and the positive consequences on the performance and scale of our local VC industry. My point is only to say that we don’t have the same probabilities in Europe to succeed at a very large scale than in the US while we have an easier way to adapt and scale-down when required.

Wise European investors will stop waiting for billion dollar exits and accept the fact that most of our good European companies will exit in the tens or couple of hundreds of millions even when successful. An interesting plan B, to my mind, would be to consider short-term exit options for the good companies that could be either operating in a tough market in the next years or could struggle to raise money in the short / mid term. Remember that Private Equity funds are loaded and are usually big supporters of the build-up playbook.

Also, many companies that IPOed in 2021 or before, are also cash rich and might not be able to deliver their promised plan organically in this new market landscape. There is still a strong appetite for consolidation in the market, and solid yet small companies are attractive in such a scenario. Surely, valuations are not to be compared to 2021 levels and should mostly end in the 6–12x ARR range, depending on the growth trajectory and the addressed market. But it is still better to net a few millions for each founder, return a decent multiple to the early backers and accept that this was not a multibillion euro kind of company, than burying everyone’s head in the sand hoping that the market’s gods will help out. While the horizon to liquidity, and the expected valuations at exit, must be adapted to the new market conditions, there are positive ways, for whoever adapts timely, to generate positive returns — and that could be a smart plan B.

Conversely, for the best scale-ups, full of cash and with a strong paper value, playing the consolidation game as a buyer is one of the most exciting options that they could find on the market to sustain their growth and justify their 2021 value.

Now that it seems clear that we are in a new phase of the market, whether financially speaking or business wise, what should entrepreneurs do on their day to day to adapt? Let’s discuss it in the next chapter.

You can also find the 🇫🇷 version of this paper in Maddyness here.