The Changing Landscape of Venture Capital in the Wake of Tech Market Corrections
In May 2022, around the time of Impression Ventures 2022 annual meeting, the VC community was grappling with the paradox of soaring private tech valuations and record amounts raised, against a backdrop of a plummeting public tech market valuations, which were down by a quarter. Fast forward through a turbulent twelve months marked by the failure of SVB Bank and we find that these market inconsistencies are completely corrected.
The Buffet’s Tide Analogy
In line with Warren Buffet’s infamous analogy of the tide going out, we have observed the market correction for private tech creeping in slowly. The tide’s retreat has revealed those who have been ‘swimming naked’, that is, the businesses that were artificially inflated and have been left exposed by the market correction.
Several data points illustrate this shift, all telling a similar story: we’re witnessing a rapid return to long-term norms or medians across valuations, amounts raised, and companies funded. However, this return to normal isn’t without its massive hangover.
The Venture Capital Hangover
The VC hangover presents as a large pool of companies that aren’t getting funded and are unlikely ever to secure funding. To illustrate the scale of this issue, let’s travel back to 2018, a typical year when approximately thirty thousand startups were funded, each with about 18 months of runway. Going back beyond that, to the early 2010s and the stats getting even scarier. Fast forward to 2021, and we saw a 25% surge in the number of funded companies compared to 2018, with over double the amount of capital raised. This massive increase in funding is extending the runway of 2021 startups to a staggering 30 months on average. This spike was expected to be eroded by high tech salaries at the time, but that trend has largely evaporated, because of the combination of layoffs and normalization of salaries.
The silver lining for venture funds is a return to the pre-bubble number of deals and investment volumes. In particular, deal sizes have reverted to a normal 18-month runway. However, the normalization of 2022 has left its mark on both the private and public markets. Public markets saw a massive 90% drop in exit activity; including buyouts, public listings, and mergers and acquisitions. The total value realized through exits in 2022 was $71 billion, a low not seen since the mid 2010s. We expect this to impact the ability of venture funds to top off current funds or raise new funds, restricting the supply of new capital.
A Double Low Tide in Venture Capital
We’re currently experiencing a double low tide in VC, leaving an enormours number of people ‘swimming naked’. On one hand, less capital is being recycled via IPOs and M&As. On the other, we have a bumper crop of 2021 companies seeking follow-on rounds. The venture sector’s hangover is acutely felt in the later stages where capital demand outstrips supply by a ratio of 3 to 1, a significant shift from the rough historic balance of 1 to 1.
Demand is easy to understand, there are simply more startups than there ever have been.
On supply, funds are largely sidestepping new equity investments, focusing instead on supporting their best portfolio companies and shying away from any companies showing signs of distress. The use of SAFE and convertible notes has surged, and valuations are only reluctantly, by investors and companies alike, being set via equity rounds. From Carta: At least 40% of all new fundings at both Series A and Series B were bridge rounds in Q1, which in the case of Series B is more than double the rate of a year ago.
Further Demand
Large Language Models like ChatGPT are a serious deflationary force in tech — it’s now easier to launch a new startup with no engineers, ChatGPT or Google’s Bard can help a solo founder do background research, code an MVP, launch a new website, and build an automated marketing campaign to acquire customers all in a few days. In theory we should see an explosion of new LLM assisted startups in the coming months. This will cause even more demand for funding.
The other major wild card is an interest rate caused recession. If it arrives and if it comes with significant workforce layoffs, we could see an explosion in startup creation as well, as those unemployed workers look to entrepreneurship to put themselves back to work, causing even more demand for funding.
The unfortunate reality is that there is no immediate relief in sight for those seeking venture funding. It’s probable that a disproportionate number of the 2018–2021 startups will start to shut down in the coming months, leading to a rebalancing of supply and demand. We don’t anticipate equilibrium to return to supply and demand until at least 2024.
The year ahead promises to be an interesting one as we navigate these changing tides in the venture capital landscape.
