The startup boom over the past decade has been a bonanza for venture capital investors. Venture capital investments racked up a median net internal rate of return (IRR) of 22.7% for vintages from 2009 to 2019—the best performing private capital asset class (outperforming private equity, which clocked in at 19.2% for the same period), according to Preqin1.
Yet that boom has started to fizzle. As the era of low interest rates and easy monetary policy winds down, disruption from Russia’s war in Ukraine, a wave of banking failures at the start of this year and hard-to-shift inflation have dampened sentiment.
All of that has had a cooling effect on dealmaking activity. While investments hit $95 billion in the first quarter of this year—a 10% increase on the final quarter of 2022—that was skewed by two large US deals (OpenAI raised around $10 billion and Stripe raised about $6.5 billion), according to Bain & Company2. When you strip out those two deals, global venture capital investments declined 9%, with the US dropping 7%. Activity remained subdued in the second quarter, with global investment coming in at $77.4 billion, with just under $40 billion in the US and $13.5 billion in Europe, KPMG data shows3. Dealmaking is also slower as investors take a tougher stance on pricing, which drags out negotiations and means deals are taking longer than usual to be completed. This normalisation of investment pace is positive when compared to some of the excesses of the prior period.
The dealmaking squeeze has had an outsize impact on late-stage growth companies, which are finding it harder to raise capital unless they reset their valuation expectations. Stripe, for example, had to slash its valuation to $50 billion to get its financing round completed—almost halving from its peak valuation of $95 billion hit in 2021. Down rounds are now at their highest since 2020, with the number likely to increase in the months ahead as investors continue to feel uneasy about valuations and a lack of exit opportunities.
“The dealmaking squeeze has had an outsize impact on late-stage growth companies...”
The IPO market remains moribund, with activity falling 5% in the first half of the year compared to the same period in 20224, which ended the year down 61% by deal value (in the Americas alone, IPO activity slumped to a 20-year low, according to EY5). With a closed IPO window and reducing cash runways, some late-stage companies may have to seek out financing at more attractive valuations and terms for investors.
However, while the backdrop is less supportive, the markdowns in valuations so far have largely been due to company-specific reasons rather than any broader contagion from the downturn in public markets.
An investor-friendly landscape?
Given that backdrop, deals are likely to be structured more favourably for investors if companies want to access new financing. Pitchbook says the market has become the most investor-friendly in decades (as underscored by the increase in down rounds)6. According to Carta, an equity platform for start-ups, almost a fifth of all venture deals in the first quarter of this year were down rounds.
The venture capital secondaries market is also likely to prove appealing as existing investors, founders or employees seek to cash in their stakes, with shares in startups trading at a discount of 61% compared to their most recent primary round valuations, according to a report published in June by Forge7.
This market repricing will favour managers with experience and good industry and sector expertise. Almost three quarters of aggregate capital raised in 2022 went to experienced venture fund managers that are on fund four or higher, according to Preqin8.
Three areas that are likely to fare better in the current environment are artificial intelligence, alternative energy and life sciences. Investments in generative AI technology are attracting increased interest, while the geopolitics and the shift towards net zero strategies are fuelling demand for non-traditional energy sources, such as cleantech and battery storage.
The tighter funding conditions mean founders and entrepreneurs need to get a firmer grip on their financial operations and ensure their business models are robust. In this environment, three types of companies will likely emerge. The most in-demand will be the efficient and fast growers that will be able to raise capital at valuations in line with 2020 and 2021 levels. The second will be inefficient fast growers that will be able to raise capital, but at reduced valuations. The third category will be the most at risk—the slow growers with poor unit economics whose very survival will be on the line. The move towards streamlining is well underway. Data from CB Insights indicates that the average firm that raised a round of $10 to $25 million had 50 employees in 2018, while the equivalent start-up in 2023 numbered only 41. In other words, venture capital investors can still find opportunities—they are just going to need to be more selective.
- KPMG Venture Pulse Q2 2023
- PitchBook-NVCA_Venture_Monitor Q2 2023
- Preqin Global Report 2023: Venture Capital (sample pages)
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