Trouble in VC paradise
It’s easy to assess listed index performance and see that 2022 has been a bear market, with equities down sharply and even the resources index on the JSE having given up nearly all its year-todate gains. It’s not as easy to think about the downstream impact on the private market, in this case the venture capital ecosystem, as you can’t pull that up as a stock code.
I’m seeing founders on Twitter panicking about liquidity drying up, particularly for the Series C rounds and later. This feedback from the coalface is as close as you’ll get to a stock code in this space.
You see, listed equities weren’t the only beneficiaries of stimulus. Crypto exploded at the same time, as “cheap” money makes it easy to play with nonyielding instruments. There’s no greater example of this than nonfungible tokens (NFTs), with the bottom falling out of that market (shock, horror). Naturally, venture capital also got a slice of the action, with start-up founders scrambling to raise seed and early-stage rounds while the taps were flowing.
Venture capital funds depend on a functional relationship called power law, which means that the returns of the fund will be skewed towards just a handful of investments. There are a couple of reasons for this. First, many of the investments will fail outright, which isn’t a base assumption in any public equities fund. Second, the investments have the potential to give eye-watering returns, so the venture capital fund aims to win big on a few punts and lose on the others.
If you haven’t heard terms like “scale”, “total addressable market” and “how do we 10x this?” then you haven’t engaged with venture capitalists or founders before.
This creates a culture of deploying capital quickly and widely. In a bull market, founders themselves are highly valuable assets, as they bring ideas to the table. Software developers (or “devs”) earn more than the founders, as the skill is in high demand and you can’t build a tech business without them. The opportunity for the founders lies in the equity, aligning their interests with those of the venture capital investors.
In a bear market, things look different. The tech-heavy Nasdaq is trading at levels last seen in December 2020. As I’ll explain, this isn’t good news for venture capital fund economics and therefore also not for founders, especially those raising funds in later rounds like Series C.
Early-stage rounds place limited focus on the financials, with investment often made based on a pitch deck alone. Seed investors are typically technology experts, looking for people with good ideas and the ability to execute them. The goal is to build something capable of raising money at a far higher valuation in subsequent rounds, giving seed investors the opportunity to mark-to-market the investment and show a strong return (on paper at least). This isn’t the “greater fool” strategy seen in NFTs, as the founders genuinely create value on that journey by building out the technology and proving a use case.
This isn’t terribly different to junior mining. When commodity prices are strong, junior miners get out the drills and invest in resource development. I’m seeing this on Sens now, with frequent announcements of drilling results by various companies. When commodity prices are weak, this tends to dry up. This is the key point that tech founders are about to learn the hard way.
Later-stage rounds are pre-IPO rounds, so investors know how to build a discounted cash-flow model in Excel rather than how to code an app. The exit multiple is based on the likely outcome of an IPO, which varies wildly depending on market cycles. The discount rate is based on a riskfree rate plus a hefty premium, with that rate increasing based on a tightening of monetary policy by the US Federal Reserve.
The net result is a squeezed Series C valuation, which is causing havoc for founders who raised Series B rounds at huge valuations and piled the cash into teams of expensive developers. This creates genuine risk of failure for businesses that have already made it so far. As Series C is the “exit multiple” for earlier rounds, it won’t be long before the pain is felt at all levels.
What does this mean? I think fewer start-ups, lower developer salaries in time to come, a collapse in the NFT market (and perhaps broader crypto) and a lack of IPOs in tech. My hope is that a sharper focus from venture capitalists on quality opportunities will, however, ensure that we all continue to benefit from clever people with innovative ideas.
The tech-heavy Nasdaq is trading at levels last seen in December 2020. This isn’t good news for venture capital fund economics or for founders