Yesterday: Fear of Missing Out
In many ways, the early-stage technology boom of 2019 – 2022 can be characterized by “FOMO” or the fear of missing out.
During this time, strong performance from the public markets trickled into the private landscape and venture capital investors were eager to make investments. Simultaneously, ease of fundraising and the subsequent influx of capital led to increases in dry powder, priming funds to become increasingly more active.
When combined with a growing number of sensationalistic headlines and an unprecedented boost to technological innovation catalyzed by the pandemic — among several other factors like the advent of crypto and lags in global supply chains — the fear of missing out on the right opportunity created the perfect conditions for a highly active venture market.
High Premiums, High Prices
Logically, this increase in activity led to an increase in premiums — the market was prone to produce increasingly larger and more frequent capital raises, and valuations skyrocketed.
This trend was particularly salient in the technology industry, where early-stage entrants were raising record-breaking amounts. For instance, according to a report published by Adventis Advisors, the average EV / Revenue multiple for a sample set of SaaS companies in 2019 was 9.8x. By 2021, the same multiple had expanded to 20.0x. Similarly, a report by Pitchbook states that the average valuation of early-stage ventures was $169 million in the first quarter of 2022, an 100%+ YoY.
To put this into context, I remember when Moonpay — a cryptocurrency payment service provider founded by a fellow Georgetown alumnus — raised a whopping $555 million Series A round led by Coatue at a $3.4 billion valuation.
New Kids on the Block
The idea that venture investments could be insulated from volatility in public markets attracted non-traditional players to the asset class, including hedge funds and private equity firms.
During this period, I recall an interesting conversation I had with a friend who worked as a consultant at Bain & Company advising funds like Tiger Global on various aspects of deal sourcing and due diligence. He mentioned that Tiger Global and several other players were looking at essentially every deal available on the market — they adopted an index approach, aiming to invest in entire sectors by allocating substantial capital across multiple ventures within the same industry. Notably, A16Z employed a similar strategy with their Crypto fund when cryptocurrency-based ventures surged in popularity.
Explosive Growth vs. Profits
In terms of investment philosophy, the period between 2019 – 2022 marked a shift in perspective — funds went from valuing explosive growth to prioritizing a sustainable path to profitability.
In the past, investors emphasized a firm’s ability to scale rapidly and capture market share (even before turning profitable). This philosophy is exemplified by pre-profit stories like WeWork and Uber, but also by several others that went public during the SPAC craze of 2020 — 2021.
At the time, I worked in the investment banking industry advising both SPACs and their acquisition targets, and I recall the emphasis on growth rather than immediate profits being quite clear; relatively new, early-stage companies with minimal traction would go public via acquisition at astronomical valuations. Matterport, a spatial data company that went public via SPAC at the time, was awarded an unexpectedly high valuation of $2.9 billion, only to experience a decline in its share price within a few months.
That being said, the shift towards profitability came to the forefront (as demonstrated by Softbank’s headlines). Today, early-stage investors are increasingly looking for ventures with a clear path to profitability — ensuring long-term success and return on investment.
Today: Joy of Missing Out
As Chua Lock, the CEO of Vertex Holdings, so aptly put it: if the venture capital industry was marked by the “fear of missing out” from 2019 — 2022, today’s market is characterized by the “joy of missing out.”
Just as upswings in public markets once trickled into the private ecosystem, macroeconomic uncertainty, volatility, and overall instability cascaded down to the venture capital asset class. Both domestically and internationally (e.g., India, China, and other Southeast Asian countries), we are observing investors employing increasingly more cautious approaches to their investment strategies. This is especially true at a earlier stages — as mentioned by a colleague and experienced early-stage operator, companies that are performing 3x better this year are still having a lot of trouble raising capital.
Rough Fundraising Environment
The current macroeconomic conditions have made fundraising more difficult for early-stage venture capital funds. Due to a series of macroeconomic factors (as well industry-specific traits like the SVB debacle), institutional investors are becoming increasingly selective when allocating capital to funds. In turn, this has led to a more competitive environment for early-stage funds as they strive to prove their ability to generate a strong ROI in the long-term.
Given the unfavorable fundraising environment aforementioned and with dry powder gradually decreasing, the deployment of capital has become more limited as well. It follows that funds are becoming increasingly selective, with many choosing to re-invest remaining capital in current portfolio companies that they are more familiar with.
Several funds with more substantial capital reserves are also shifting their focus to later-stage companies, which tend to have proven business models and more reliable growth prospects. In the same vein, I observed the same dynamic at Techstars — a prominent startup accelerator — as the outlook behind prospecting for new startups shifts. In many ways, the accelerator is emulating the investor market by becoming increasingly more selective; scrutiny on a given startup’s current ability to generate cash flow has largely increased, to name one example.
That being said, despite noticeable increases in overall levels of caution, the rationale behind investment strategies remains largely the same — funds are still prioritizing profitability over rapid growth potential. In fact, many could argue that the current environment further catalyzed this trend.
The concept of “zombie funds” — funds that have not and will not make new investments for significant period of time — is also becoming more prevalent. While relatively rare during a bear market, the lack of available capital, poor fund performance coupled with down rounds and limited investment options creates an environment where some funds continue to manage their existing portfolio to generate management fees, but they are unable fundraise again.
In turn, this challenging fundraising landscape could potentially lead to consolidation among early-stage fund as smaller players merge or are acquired by larger competitors. The result is more concentrated portfolios and fewer capital raising opportunities for startups.
Some say this potential consolidation could help stabilize the venture capital market and create stronger, more resilient investment vehicles for institutional investors. On the other hand, some claim that the loss of optionality in funds could be detrimental to the early-stage venture environment in the long-term.
Tomorrow: a Sea of Opportunity
As interest rates continue to rise (and with the idea that private markets are not marked-to-market in mind), it is likely that we will continue to see big changes in the venture landscape this year. Firms and investors alike will have to focus on cash burn rates and raising capital will be a more strenuous process due to heightened due diligence. Moreover, other factors like the migration of employees to AI ventures, contribute to the uncertainty.
That being said, as the age-old adage goes: “the best opportunities often appear in the roughest of times.” In the investment banking industry, for example, the concept of boutique shops (i.e. Evercore, PJT, etc.) that dominate today’s market grew in popularity after the Subprime Mortgage Crises. For funds with capital, the current environment could be an amazing opportunity to find hidden gems; for some firms, this could be an opportunity to stand out at a time where the number of investments and valuations have decreased.