“Timing is everything".
That's especially true with financial markets. And, unfortunately, we now find ourselves deep in bear country.
Some pretty ugly macroeconomic conditions have propagated a wave of fear that has quickly filtered all the way down into early-stage VC financing.
Which, isn't exactly a rosy place to be for companies intending to raise a Series A or B round anytime soon.
One CEO I spoke with, who is currently raising a Series A and has been in extensive talks with VCs who have yet to pull the trigger, said "the market has all but cruised to a halt".
Another CEO, who recently closed a £4m Series A round but has not publicly announced it yet, by-passed VCs altogether and raised *the full amount* from angels.
For context, they previously raised a £3m seed. And, 70% of the Series A was contributed by those who participated in the seed.
Could this become a thing? Will the 'A' in 'Series A' stand for 'angel' this year?
Twitter has been lit up with commentary on the VC pullback, with big-time industry figures like Keith Rabois (General Partner at Founders Fund) and Brian Chesky (CEO at Airbnb) throwing around scary numbers like "2000" and "2008".
Whoa, let's not go there just yet. Time will tell how deep this hole will go. But, it does feel like we were due *at least* a market correction from a trajectory that was unsustainable.
So, yeah, a total buzzkill.
Frustratingly, the venture capital market can often feel like a black box to founders.
Whilst signals do trickle through social media, personal networks, and existing cap table investors on the state of the VC market, it's like gathering a handful of pieces for a much wider puzzle. You don't really get the full picture.
Could I close a round now? Who from? How much? And, on what terms?
Ultimately, the only real way to figure out the answer to such burning questions is to actually embark on a fundraise and test the appetite for equity in your specific company. Since, no two are remotely the same.
Whilst a specific "yes" or "no" can't be gleaned without actually pitching VCs directly, there are themes that emerge in any significant market shift like the one we're in.
Since most of the commentary on this topic seems to be coming out of the US, I decided to ask a few UK-based VCs to get a sense of where the market is at on this side of the pond.
- Rob Moffat, Partner at Balderton Capital
- Hector Mason, Partner at Episode 1 Ventures
- Natasha Jones, Investor at Octopus Ventures
- Rich Ashton, Managing Partner at First Party Capital
- Mattias Ljungman, Managing Partner at Moonfire Ventures
- Chris Tottman, General Partner of Notion Capital
So, let's dive in.
What the VCs say
Depending upon when you raised your last funding round will significantly impact how comfortable you're sitting right now.
Startups that last raised 12-24 months ago and are heading back to the market for their next round are facing fewer suitors.
Whilst capital is still being deployed by VCs, the volume has certainly been turned down below 11.
Expectedly, valuations and round sizes are trending southward.
Rob Moffat, Partner at Balderton Capital—who invest from Seed to Series C—says they have not pulled back, but they have noticed a change in round terms.
"We have not changed our approach but we are seeing some valuations and round sizes get back towards where they should be after some excesses last year.”Rob Moffat - Partner, Balderton Capital
In a newsletter to portfolio companies, Mattias Ljungman said:
"Valuations have fallen dramatically to pre-pandemic levels while expectations and due diligence have increased.
Companies will have to achieve the high growth of the past year with far less capital and those that could have coasted along in previous times will perish.
High bars are being set by investors and companies will have to focus to reach them."Mattias Ljungman - Managing Partner, Moonfire Ventures
This could put many startups that raised at 'peak valuation' (2020-21) in a sticky situation when they eventually return to the market for more capital.
And, even now, there is concern valuations could continue to fall further.
This places a *much greater* emphasis on round valuation strategy. Taking the highest offer now may backfire big time if valuations recede materially beyond where they are today for a sustained period.
A high-priced 'vanity valuation' could spiral into a down-round (or worse) in 1-2 years time.
This is something that's on the mind of Rich Ashton, Managing Partner at First Party Capital:
"We have been advising our portfolio companies to think carefully about the valuation that they will be able to achieve at the funding round after their next one.
It's tempting to take the highest offer possible in order to minimise dilution (and possibly for bragging rights in tech circles).
We have seen deals approaching revenue multiples of 100x ARR, but what happens when multiples are back at 20x at the next round?
That company will need to have grown 5x just to maintain its previous valuation. This leaves very little margin for error and will force many of these companies into taking a down round.
This can be a company-killer, dampening team morale, making it harder to retain and attract top talent.
I imagine that even some of the most aggressive VCs who prioritise hyper-scaling over profitability, will be reviewing their portfolio companies' growth plans and delaying major investments into new markets and verticals, or cutting back on new hires.
It's by no means all doom and gloom, perhaps just a return to more prudent operating procedures."Rich Ashton - Managing Partner, First Party Capital
Deal closing momentum is also retracting, according to Natasha Jones, Investor at Octopus Ventures. Here's why:
"I’ve seen the pace of deals slow to allow for more time in DD, to test and validate business assumptions. Investors are still active but the bar for conviction is higher."Natasha Jones, Investor at Octopus Ventures
And, under the hood, expect deployment strategy to also change.
Matt Turck, Partner at FirstMark Capital, posted an incredible hot take titled "The Great VC Pullback of 2022" a few weeks ago that you should definitely check out if you haven't already. It dives into this subject from a US perspective, themes of which are inevitably rippling into the UK.
"VCs are likely to need to use more capital to support their existing portfolio, as opposed to making net new investments... inside rounds [will] mostly [be] used to support portfolio companies that are getting short on cash.Matt Turck - Partner, Firstmark Capital
Matt also said the “flight to quality” trend will accelerate, so expect to see more capital consolidated with the elite of outperforming companies.
Basically, if Google or Facebook were a Series A company now, VCs would be piling more money into them in favour of spreading capital with riskier unknown startups.
This is something Chris Tottman, General Partner at Notion Capital, reaffirmed for the UK market and quantified in terms of what growth rate thresholds you'll likely need to hit to close a round:
"We've done more than 100 Deck Hacks in the last 6 months to help founders pitch to VCs. At the same time public market valuations have been crashing, this is filtering into private valuations.
Investment dollars and the best people will flow more aggressively to the best companies. So the best companies are frequently growing the fastest. Growth is VC catnip and always will be.
If you're not growing 3x plus pre-A Round then venture is probably off the table and the further below 2x post-A the harder funding conversations will be.
Winners [will] extend their lead. In capital constrained markets the distance from the best companies in a category and everyone else will spread massively.
The 'me too' competitors will fall away. So what is the uniqueness of the business and how is this transforming a market becomes key. Gaining rapid market share efficiently and the market thesis needs to be incredible.
VCs will debate Founder<>Problem Fit much more than before. Will these people be the winners and what's the evidence that they have an inside track?"Chris Tottman - General Partner, Notion Capital
In times of panic, it's human nature to mitigate risk and recalibrate one's investment decisions towards familiarity, fundamentals, and prior signals of success. VCs are not immune to this.
So, expect to see funds concentrating more capital into:
- ⭐ Founders with a successful track record
- 📊 Companies with solid unit economics and capital efficiency
- 📈 Companies with hypergrowth
That was already the case, of course. It's just likely to increase more.
And, the bar for each will be higher.
For example, whereas the top 5% of companies making it to the last stages of investment consideration in each category may have been funded before, it could be more like the top 1-2% now.
Companies that raised in 2021-2022 based heavily upon a flamboyant pitch, unsustainable growth metrics, and weak product-market fit signals are out of favour.
Hector Mason, Partner at Episode Ventures, commented on this:
“Funds still have money to invest but some are deploying at a slower pace making it harder for any startups other than the very best to raise.
Speaking to the right investors and running a tight process to build momentum in your round has rarely been more important.”Hector Mason - Partner, Episode 1 Ventures
Breaking that down, VCs are looking favourably on capital-efficient businesses as there's a lower risk they'll need to raise again in what is a "difficult environment".
Natasha Jones expands:
"We’re seeing a renewed focus in the market on product monetisation, growth and margin profiles."Natasha Jones, Investor at Octopus Ventures
So, expect a shift towards startups operating closer on the spectrum toward 'business fundamentals 101'.
What that looks like in reality could be a kind of 'pivot to profitability' wave.
Many startups will be considering YC's 'Default Alive' framework, in which if the current growth rate and expenditure trajectory continue, when does the company run out of runway? i.e. how do we make changes so that it doesn't?
That likely involves cutting costs, taking fewer risks, and allocating capital to 'proven' areas of ROI. Potentially, at the cost of achieving or sustaining hypergrowth if doing so is wildly unprofitable (i.e. not following an Uber-like growth model).
From the Moonfire Ventures newsletter, Mattias Ljungman said:
"As a founder, your priority is now survival.
Your burn rate, cash position and runway are your new golden metrics.
Investors will focus on your burn and want to know when you will hit cash flow breakeven. Investors will no longer just focus on growth and traction, but also what the cost was to get you there (ultimately showing your ROI).
You should also be talking about your break even point, which is the ultimate number to get control of your destiny. When you have a handle on that number, you can choose when you raise or not."Mattias Ljungman - Managing Partner, Moonfire Ventures
But, the 'pivot to profitability' approach does raise questions.
Some startups may be able to hunker down—or even thrive—through the turmoil and come out the other side all guns blazing.
VCs are likely to be comfortable with risk in certain situations, especially if their portfolio startup's services are in *more demand* during a downturn (e.g. Zilch).
But, for other startups, 'pivoting to profitability' could be a decision that leads to leaving the VC-pathway altogether. Cutting costs can mean cutting growth. Perhaps, unnecessarily.
Mainly because they'll take less risk, moonshots will turn into low-orbit shots, growth naturally slows, and the return potential that VCs look for (unicorn hunting) slips away.
It all boils down to execution, in which there is a lot of bandwidth for manoeuvrability within a 'pivot to profitability' strategy—particularly across different business models and sectors.
Another cohort of startups will likely reign in burn with the objective of achieving more with less—so technically 'Default Dead'—but the life support machine is within reach.
For example, shifting operational strategy so that *they could* become profitable or break even quickly (i.e. less than a quarter) in the event there are no VCs lining up to invest.
Chris Tottman commented on this topic:
"Everyone obviously wants the capital to last longer and people will be very schizophrenic around their advice. Many existing investors, not unreasonably, will want the capital to last longer before flaming out or to get to cash flow breakeven. Now does that mean you become uninvestable by VC?
Others with more risk appetite will want you to be bolder and efficient by focusing resources on a fundamental inflexion point in your trajectory which transforms both growth and efficiency. If the latter is not there then the former is much more important but this is often drowned out in "cut costs, extend the runway".
It's all on you to decide. We love founders so best of luck out there."Chris Tottman - General Partner, Notion Capital
On twitter, David Sacks, Partner at US-based Craft Ventures, also astutely pointed out:
"Instead of thinking about whether you are “default alive” vs “default dead”, think about whether you are “default investable” vs “default uninvestable.
“Default alive” is almost an impossible standard for early-stage startups since it means being cashflow positive. On the other hand, “default investable” means that your metrics are good enough to raise another round in the current environment.
“Default alive” requires you to make revenue growth assumptions, which can be risky in a downturn.
“Default investable” requires you to understand VC criteria — also subject to change, but largely ascertainable by talking to VCs.”David Sacks - Partner, Craft Ventures
Additionally, partners at VC firms *that are still investing* will likely have less overall time to receive pitches from new companies.
Why? Because they'll have to spend more time putting out fires with existing portfolio companies that have hit the end of their runway.
This means screening meetings even more heavily to those that demonstrate the most powerful signals. So, a *killer intro* has never been more important.
On the flip side, be conscious of those that are taking your meeting. It doesn't necessarily mean they have any intention to invest, which can create a sense of false momentum. In Y Combinator's email to its founders, they said:
"The number of meetings investors take don't decrease in proportion to the reduction in total investment. It's easy to be fooled a fund is actively investing when it is not."Y Combinator
Why? The current environment means a VC's limited partners "will expect more investment discipline".
Top tier funds that have access to capital will slow down their deployment, whilst lower-tier funds that may struggle to raise from LPs in the foreseeable future may halt deployment altogether.
Here's some more standout feedback from that same YC note:
"If your plan is to raise money in the next 6-12 months, you might be raising at the peak of the downturn. Remember that your chances of success are extremely low even if your company is doing well. We recommend you change your plan.
For those of you who have started your company within the last 5 years, question what you believe to be the normal fundraising environment. Your fundraising experience was most likely not normal and future fundrsaises will be much more difficult.
If you are post Series A and pre-product market fit, don't expect another round to happen at all until you have obviously hit prodcut market fit.
Many of your competitors will not plan well, maintain high burn, and only figure out they are screwed when they try to raise their next round. You can often pick up significant market share in an economic downturn just by staying alive."Y Combinator
And, if you're thinking about bridge financing your way through the pullback, US-based VC Kirby Winfield commented on twitter:
"The days of outside bridges and extensions are largely over. Look around the cap table and ask current investors where they stand on a bridge."Kirby Winfield - General Partner, Ascend.vc
So, how long is this downturn going to last?
Y Combinator answered this question pretty succinctly in their note to founders: "No one can predict how bad the economy will get, but things don’t look good."
So long as the public markets are negatively impacted by global instability, the appetite for risk will propagate all the way back down the capital chain to early-stage private investing.
As per Moonfire Venture's newsletter:
"This current cycle has been triggered by the growth of inflation brought on by global political instability caused by the war in Ukraine, high energy prices and continued supply chain woes.
In turn, this has caused interest rates to start to climb and investors have moved away from public growth stocks."Mattias Ljungman - Managing Partner, Moonfire Ventures
Why are public markets important?
"They are the ultimate exit root for tech companies and they are also a leading indicator of valuations in the private markets.
Private markets move much more slowly as they are only repriced once a transaction happens, which can take 12-24 months.
Hence we are seeing the worst effects in growth stage investing, as their expected IPOs are so close and their valuations so overinflated.Mattias Ljungman - Managing Partner, Moonfire Ventures
So, how long should founders plan foor, ball park?
"The tech market works in extremes, from irrational exuberance to market despair, meaning this downturn could be a Minsky Moment, a downward spiral of interlocking and reinforcing factors.
This market could be with us for the next 12-18 months or longer. As a founder, you must prepare to endure a more demanding period that will shape and challenge you like never before.Mattias Ljungman - Managing Partner, Moonfire Ventures
What's gonna happen to startups that can't close a Series A or B round from VCs?
Great question. There are other avenues to closing a Series A or B:
👔 Strategics. Expect to see an increase in the volume of startups knocking at the door of strategics for capital. Big corporations have different motivations for investing in a startup, so they could be willing to do a deal when the VC avenue is closed off.
Namely, they have strategic reasons for wanting to get closer to emerging technology companies. And, their investment return is not restricted by the power-law fueled 'unicorn math model' that VCs are often wedded to.
But, there's always a catch. Strategics often want to impose restrictive terms such as blocking a company from working with competitors. Or, locking in the right to buy the company at a certain milestone or in certain situations, which is likely to lead to a cheap acquihire.
Plus, it'll be tempting for a strategic to just skip the whole investment process and offer to buy out the startup pitching them on meagre terms. After all, they know the startup pitching them is heading out of runway and has few options to pick from. It's a buyer's market.
😇 Angels. I'm very curious to see if the angel-financed Series A structure has wings. Whilst the size of such rounds will skew low, more akin to a conservative seed-sized round in 2020-21, angels may be prepared to pump in life-supporting capital that a startup can use efficiently to make it through the storm.
Optimistically this would be at a decent mark up to the seed round, but, less optimistically, at parity or a notch just above would get the job done.
A major difference from both the 2000 and 2008 financial crashes compared to now is the mainstreaming of startup investing. And, the huge amount of wealth generated from it.
It feels like everyone invests in startups these days. Musicians, actors, sports players, founders, bankers, you name it. And, those people have different motivational incentives amongst themselves, let alone compared to VCs. It's not all about the money and unicorn-returns math model, so many are still likely to buy into a startup mission they deeply connect with.
🏢 Family offices. Today, family offices play a meaningful role in the startup funding ecosystem, from seed stage all the way up to IPO. Particularly in certain categories where VCs tend not to dabble as much—e.g. retail, hardware, gambling, and entertainment.
According to the FT "three-quarters of family offices surveyed globally by SVB (Silicon Valley Bank) and Campden Wealth said they made venture investments in 2021, about double the share that were striking deals a decade earlier".
And, the average family office held "direct stakes in 17 companies".
That's welcome news. Unlike VCs, family offices do not have outside investors to answer to.
Whilst they are not immune to the effects of a bad economic environment, they also operate without fiduciary constraints and can move decisively by placing high-risk bets where they have conviction.
For example, Gary Lauder, a grandson of the founder of cosmetics group Estée Lauder, who operates Lauder Partners, said to the FT:
“There are times when I invest in something based on a short description, liking the people and not much due diligence - if I was a fiduciary [managing other people’s money], I would have to do more due diligence."Gary Lauder - Managing Director, Lauder Partners
Historically, family offices have had a tough time positioning themselves advantageously into the startup funding ecosystem. They are not exactly a 'first look' opportunity for founders, who mostly want to raise from VCs with the best reputation, connections, expertise, and other value-add services.
A handful have built direct relationships with top tier VCs (who lead rounds) in order to get access to quality deal flow. This means they rarely lead themselves, which is the key to getting a round done.
Whilst a portion of family offices are likely to pullback from early-stage private investing in the current climate, maybe it's also an opportunity for a few to shine by taking the lead, being bold, and building rapport with cash-strapped founders.
Family offices could prove to be a viable avenue *for some*, particularly if there is an overlap in the industry in which a startup operates and the industry upon which the family office's wealth originates.
What if those options are off the table?
Big question. There are *lots* of other ways to finance a startup.
Detailing them all is outside the scope of this article. So, we're going to dive into them properly soon.
To receive more content like this, drop your email below. 👇