Some investors I spoke to in the second half of last year complained about the exuberance of the venture capital market. They yearned for a slower pace of transactions and even lower valuations.
Their wish came true earlier this year following a stock market correction. And despite the new climate of late-stage venture capital-backed valuation pressure, there are plenty of reasons to expect the market to ride out the storm.
Stakes in pre-IPO companies that had their last funding event in the second half of 2021 now trade on average 60% less than in their previous round, according to Andrea Walne, general partner at Manhattan Venture Partners, a firm focused on on the secondary ones. investment firm.
Instacart management, in an unusual move, reduce its internal valuation nearly 40% in March. That brought the grocery delivery company’s value more closely in line with DoorDash, a key public market comparable, whose shares have fallen nearly 50% in the past six months.
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These are deep discounts, implying that many late-stage companies are now significantly overvalued. Yet venture capitalists, including some focused on the late-stage market, argue that discounted prices are necessary and even healthy.
Despite lower valuations and near-closed IPO markets, investors are hopeful, at least for now, that their portfolio companies will have time to grow in their valuations.
Unless the stock market downturn extends significantly beyond this year, many private companies will likely be able to avoid the much-dreaded down cycles, industry jargon for sell-off stocks. lower than the previous funding cycle.
Investors say many companies that held a fundraising event last year raised more funds than needed. These startups could limit their spending and try to make that capital last as long as possible.
Even in the event that a company needs a fresh injection of cash, it still has various tools at its disposal.
First, they could raise an extension round, selling shares at the same price as the most recent funding. Extension rounds were common at the start of the pandemic because they allowed investors to double down on promising companies at their current price. And expansions will likely show up even more this year if startup valuations remain depressed.
Kyle Stanford, venture capital analyst at PitchBook, said he expects more investor-friendly protections to return to the term sheets before a ton of declines occur. One of those terms: liquidation preferences ensuring that investors who enter the cap table later will be paid before earlier investors in the event of an exit.
For now, these structures are not commonly seen on term sheets, investors say. But they might start popping up for the riskiest and most expensive trades. By the middle of the previous decade, deal terms for a good chunk of late-stage towers, including mega-deals for Square and Box, came with ratchets. This helped investors feel more comfortable paying a higher price because they knew their investment was downside protected.
But perhaps the biggest reason investors aren’t too concerned about the possibility of their current portfolios dropping in value significantly is the unprecedented amount of capital in the system.
Venture capital funds in the United States raised more than $70 billion in commitments in the first quarter of this year, according to PitchBook data. That’s already more than half of what was raised by the asset class in all of 2021, the highest year on record. It is also larger than the combined funds committed in 2008, 2009 and 2010, the years of the global financial crisis. Investors will be eager to deploy these funds at more reasonable valuations.
Barring massive LP defaults, venture capitalists will have their coffers full for some time. PitchBook analysts estimate that this dry powder should last 2.5 to 3.5 years, a projection that excludes possible additional capital from non-traditional investors like mutual funds or venture capitalists, said Stanford. These funds will inevitably flow into existing investments, not just new deals.
And there probably won’t be a dramatic downturn in business activity. Startups will continue to be funded, even if deal sizes and valuations are lower.
Certainly, startup death rates are likely to increase in the short term. The bar for raising Series A and Series B rounds has already risen, said Michael Kim, founder of Cendana Capital, a seed-focused fund-of-funds.
But even if the US economy slips into a mild recession towards the end of this year, there is reason to believe that venture capital can weather the downturn relatively unscathed.
Stanford adds, “I don’t think the industry can ask for better terms than all the capital available right now.”
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