In the third quarter of 2022, VC funding totaled just $81 billion, according to Crunchbase. That’s 33 percent less than the previous quarter, and 53 percent ($90 billion) less than 2021. What’s in store for 2023? During our last “Coffee and Conversations” webinar, we spoke with Itxaso del Palacio and Chris Tottman from the leading investment firm, Notion Capital, who shared their take on what to expect in 2023.
Times have changed, and the surviving companies will quickly adapt to the new reality of lower valuations for cloud companies, money being less cheap, high inflation rates, and customers cutting costs while looking for faster ROI.
Despite a sharp downturn in venture investment volumes during 2022, there is a record amount of “dry powder” in the VC market, mainly focusing on earlier-stage investments, albeit in smaller volumes than yesteryears. We can also expect that the deployment of the currently available capital will probably be allocated to a higher degree to existing investments, and at a slower pace, toward new companies if the recession extends.
The seed and Series A funding market seem less affected than later rounds today, such as Series B and beyond, where 50%+ valuation cuts are expected. However, we must remember that with a long-term perspective, we are back to the historical average of 5.4X in valuation multiples of 12 months forward-looking ARR (Annual Recurring Revenues), as this diagram shows.
Today's investors are balancing investments in existing portfolio winners and looking out for quality startups offering real solutions that can thrive in recessionary times (e.g., megatrends such as ClimateTech and Generative AI Tech). Companies with proven solutions to increase productivity, automation, and efficiency always stand the best chance of securing venture capital.
It is already more challenging for companies in round B, which will probably continue during 2023 as the public market sentiment has now spread to the private markets and will undoubtedly affect earlier stages. The threshold will be higher, and the valuations will be lower than in the last two years. It is hard to say how long this will last, but if we look back to the internet boom and bust of early 2000, it could be as long as 2-3 years before we see the subsequent surge in valuations and investor sentiment.
Companies that can demonstrate traction towards profitability, with increased gross margins, highly capital-efficient, and consistent growth metrics, will stand an excellent chance to raise additional external financing even in these challenging times.
The rule of 40 (RO40) is a metric used to calculate the level of sustainability for a company’s growth. Private Equity (PE) investors initially came up with the Rule of 40 to quickly assess the performance of growth companies to find a balance between the rate of growth and the need to reach positive EBITDA. As an operator, it adds financial discipline to the decision-making process, and as an investor, it helps assess the attractiveness of a SaaS business.
The RO40 principle means that a company's combined growth rate and profit margin should aim for 40% to demonstrate capital efficiency during various growth stages. In the last 14 "bull-run" years, there was more willingness to compromise, "go for growth," and rack up the losses, willingly funded by VCs chasing unicorns. But since the middle of 2022, the market has been considerably different, with less available "crazy" growth capital and more focus on fundamentals like gross margin customer acquisition cost, and pay-back times. The result is that fewer companies will today qualify for individual leniency and trade-offs from investors when it comes to managing their burn rates.
In these new times, it’s not growth alone that is key but efficient business growth. Efficient business growth focuses on better capital allocation, investment decisions, and cutting the right costs. Thinking about your “burn multiple” is a great way to look at overall company efficiency. Your new key metric will be the “Burn Multiple” = “Net Burn / New ARR” over any given quarter. In the ideal case, the Burn Multiple is below zero, so you are adding more revenue over time than the money burnt. The following diagram can help you understand where you are in this aspect of efficient growth.
Efficient Growth measured by Burn-rate Multiples:
With a funding environment that will continue to be challenging for 2023 and possibly 1st half of 2024, especially for growth rounds, aim to enter 2024 with a 6-12 months runway.
Early-stage startups are more vulnerable during a downturn than well-established competitors because they have less cash in their coffers, often burning money every month and chasing the elusive Product Market Fit (PMF).
In other words, a startup could take a bigger hit than an established business because it's already struggling from all its inherent challenges: small team size; high burn rate; lack of resources—and now it has to contend with customers who don't have as much money to spend on products or services.
The harsh reality is that many startups will only be able to raise a new outside or inside round of funding if they can demonstrate a path to profitability while still growing efficiently, as described above. The real risk of not paying attention to this new reality and right-size the company quickly is a severe down-round or even a 99% wash-out (i.e., nominal share value for new investors to come in and save the company). The other negative consequence of running out of cash might be a fire sale with zero return for founders and most investors, or worse case, face bankruptcy or liquidation.
However, during recessionary times, the opportunity to build new companies also improves as talent is often more available and cheaper compared to the boom times. We have seen this many times before during previous boom and bust cycles.
Technology is still driving economic growth and solving some of the world’s biggest challenges. Many new VC funds are focused on climate investments, so it is a perfect time to start a “green tech” company.
More recently, we have seen a new paradigm shift in generative AI tech, spurring an enormous interest among VCs to jump on the bandwagon. Startups leveraging this new brave world of generative technology will attract funding. But don’t forget to demonstrate how new funds will be used by your startup, and make sure that the discipline of PMF and capital efficiency are not overlooked as you journey into the future.
Opportunity, ambition, and innovation don’t slow down. Experienced and savvy VCs know the best companies will form during this market correction, revealing the most extraordinary entrepreneurs. You can make this a year to thrive!