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The fall in tech companies’ stocks, problems in the supply chain, rising interest rates, a war in Europe, and perhaps apart from the dollar appreciation, all macroeconomic indices have a negative impact on the high-tech market. How does this affect startups that are raising capital in the early stages? How is investing changing? When raising capital, every entrepreneur must understand the effects of the crises on investors’ strategies.
There are seven main changes in the way venture capital firms (VCs) make investments during a time of crisis.
VCs are adopting a defensive strategy, which means that they think primarily about supporting existing portfolio companies. As for new investments, many venture capitalists adopt a “hold” strategy, which means that they wait until the market stabilizes before investing, or invest very little. The CEO of Softbank said that Softbank, which contributed significantly to the rise of valuations in PE markets, could reduce its investments by up to 50 per cent this year. In 2008, the number of investments in startups at A, B, and C rounds decreased between 40-47 per cent, and only three years later, in 2011, it returned to its original level. Therefore, although the dry powder is high (see Figure 1), its availability is low, making it difficult for entrepreneurs to raise money.
Figure 1: VC fundraising eclipsed $100 billion for the first time, PitchBook
Most entrepreneurs still do not understand the investment criteria transformation, and when they seek a VC investment, they fail to recognize that investors are evaluating opportunities through a modified set of lenses. The startup journey is essentially a journey of risk management. “Product risk” is all about whether a startup can develop a solution that works. “Market risk” is about product-market-fit and so on. “Liquidity risk”, or the risk that the company’s cash flow will run out, is a risk that startups face at all stages of their existence. However, during a crisis, liquidity risk increases significantly, yet other risks don’t correspondingly decrease.
Let’s further clarify by saying that there are liquidity indices and there are growth indices.
Insider investors committed in the round (as % of the round)
Financial capabilities of the current investors
ARR (Annual Recurring Revenue)
CAC (Customer Acquisition Cost)
LTV (Lifetime Value of Customer)
The Market – TAM
(Total Addressable Market)
Let’s imagine that each fund has a different weight matrix according to which it makes investment decisions.
In a bull market, growth indices and general indices account for the majority of investment decisions. Investors are confident that a company demonstrating growth and product-market fit will continue to grow and raise capital easily. However, during a bear market, the fear is that the cash tap will be closed, and therefore investors will place the greatest weight on liquidity indices.
The “new” questions that investors are asking are the following:
- Is this round (mainly SAFEs and bridge rounds) being conducted because the company has run out of money or because it is reaching the milestone it aspired to achieve? The current runway and the percentage of money left over from the last round can help answer this question.
- Do existing investors and/or investors who participate in the current round have the financial resources to continue to back the company during a bear market? If the company is primarily backed by micro funds or angels, then alternative funding may be required during a bear market.
- Have the existing investors in the company decided to continue investing in the current round? If they do not invest now, they are unlikely to invest in subsequent rounds, which increases liquidity risk.
- Is it possible to achieve “lean” resource growth?
Size of round
In the context of liquidity risk, many startups raise small rounds due to dilution considerations, particularly SAFEs. VCs no longer see this as the right strategic move. Investing in small rounds increases the risk of liquidity for existing investors, which could jeopardize the startup’s success with a flat or down round. Raise as much as possible: you can never tell where the market will be two quarters from now. A round gathering raised during days of crisis should provide a Runway for at least 24-30 months.
Valuation and revenues
Public market multipliers are not constant over time. 2021 multipliers are not relevant for 2022. Startups’ valuation methodologies have changed. That’s the way the industry works, even if you will enter the public market 7-8 years from today when the market is better. VCs look at the multipliers as they are today, not as they will be in the future.
After understanding valuations should decline, we can argue as to how much they should decline. Tomasz Tunguz‘s analysis (see Figure 2) shows that the “corrections” of the public market affect the late rounds, i.e. the D rounds. However, The A rounds have almost not been affected (2013-2021). Tomasz’s analysis doesn’t apply to a long-term recession but only to temporary corrections. My recommendation is to reduce valuation expectations but not too much since it is not clear whether we are in a recession or a temporary “correction”.
Figure 2: Series A and D rounds correlation with the public markets
Bear markets result in fewer M&As (and of course, IPOs). The VCs’ liquidation strategy (which lasts 8-10 years) changes during a bear market. VCs will further examine the unit economics, the CAC: LTV ratio, and the financial models to assess the company’s viability during the bear market. An unhealthy unit economics will require justification, even if customer growth shows a J-curve.
Focusing on core industries
The study “Venture Capital Investment Strategies under Financing Constraints” (University of Georgia, 2019), found that in times of crisis VCs tend to invest in their core industries of expertise. However, during growth periods, funds tend to examine investments even if they are out of their core area of expertise. When you are not in a growth period, spend your time evaluating VCs who have expertise in your field. Don’t waste time on funds that in the last two years have expanded their investments into your industry, outside of their core expertise.
Time is more limited than ever
When times are tough, VCs tend to cut their costs and reduce their human resources. As a result, processes may take longer than usual. Additionally, VCs have many portfolio companies. During periods of crisis, these companies need much more attention and assistance, and the VCs become much more active board members. They invest much more time helping their portfolio companies cut costs, renew operational models and raise additional capital. In times of crisis, investors will be “harder to get”, even more than ever. Pay attention to which investors you want by your side and who you are reaching out to and how. You do not want to find yourself receiving a time allocation from only new funds (and lately there are a lot), which have few existing portfolio companies, and a lot of free time.
After understanding the changes in the way VCs make investments during a time of crisis, here is what entrepreneurs should think about when raising capital. Try to raise money from VCs who have the resources and are willing to further support you. Do not be afraid to ask VCs: What is the current deployment percentage of the fund? How much of it is allocated to follow-up rounds and what is the fund’s historical participation in follow-up rounds of its portfolio companies? In this context, corporate VCs could be an option – these funds are less affected by crises.
Remember that 75 per cent of Fortune 500 companies were founded in a time of crisis and that VCs with vintage in or around crisis years show better returns. While raising capital in a time of crisis is much more challenging, successfully doing so may be a positive predictor of future success.