Is this the Great Reset for Venture Capital?

The public market values are falling rapidly. Venture capitalists at the growth stage are panicking. Twitter is flooded with predictions and projections that it will be difficult for a while. The negative sentiment is growing.

This is a difficult time for those who have lived their whole professional lives in a bull market that never ended. The idea that the bull markets would never end, despite the claims of many self-serving Twitterati, was always absurd. Markets are naturally cyclical, and corrections are almost inevitable.

The impact of downturns on public market investors is immediately apparent. However, for venture capital markets, it can take longer to determine the consequences. Venture capital is a broad term that can be used to describe rounds ranging from $500k pre-seed up to multi-billion-dollar growth cheques. This complicates any analysis.

Growth Investors

Market conditions are most likely to have a major impact on growth investors. Because they are closer to exit, this is why they are more affected by current market conditions. Their business model is based on a strong IPO market and positive sentiment towards M&A in order to realize their investments.

While most funds have enough liquidity to weather a period of inliquidity by supporting their portfolio with bridge fundings, the exuberant behavior of recent years has put more pressure on fund GPs. Funds that invest in the newest stage rounds (Series D upwards), where exit time is shorter, are most affected.

First, many funds have adopted shorter fundraising cycles that raise new funds every 12-18 month. This gives LPs a limited window of opportunity to show performance, whether through cash realizations or paper mark-ups. With the public markets falling, GPs will try to raise capital with portfolios that have seen significant markdowns. LPs won’t be impressed. It is possible that the entire model of writing large growth checks and generating rapid returns via public markets listings is dead.

The second reason is that rounds are often significantly overvalued due to the intense competition among growth funds in recent years. Although it was possible to find relevant comps at the time of the investment, or any other reason for paying such high prices today, this has made the situation more difficult for GPs. They may be holding shares in companies that they have paid a high price for and never see a return.

Third, certain investments made in recent years seem a bit too similar to those made late 1990s. They depend on a constant supply of capital to drive growth, and can only achieve profitability at a large scale. These companies are likely to be sold in today’s market as GPs seek to protect their investments with positive unit economics, which make them either profitable or have a realistic chance of becoming profitable.

Series A Investors

The situation is complicated for Series A investors. Multi-stage funds doing Series A might need to shift their focus in order to protect later-stage growth investments. This is a great opportunity for dedicated Series A funds to get the best deals, which are less contested.

Overall, the sentiment at Series A is positive but cautious. The challenges facing those funds right now mean that investors may have to wait longer for a growth round to be successful. Investors are aware of this fact. Two main signs of caution are present.

First, the size of round has decreased – whereas a Series A of $15-20m (or more) was possible in Europe in two years ago, now $10-15 is more common. This could be a sign that the trend is reversing and not a worrying one.

Second, investors are more selective and are increasingly looking for quality. A successful Series A round has all the components that you would have expected a few years back: revenues and revenue growth; a strong team and a large market.

Early Stage Investors

Pre-seed and seed investors in the early stages of their investment are subject to similar impacts as Series A. However, they have to be careful not to overpay for deals and focus on high quality opportunities. Early-stage investors have grown accustomed to the uncertainty of many years ahead of their companies. The general sentiment is to keep calm and carry on.

Early-stage investors often have companies due to raise funds this year. This is where a lot of effort goes into making the process as smooth as possible. Strategically, investors are also considering the best options for their next round. Some choose to fundraise internally or with full seed plus rounds. This helps position founders for Series A.

The overall picture for all types of funds is mixed. However, individual funds’ impact on the market can vary greatly depending on their past performance. If discipline is lacking, rules books have been torn down and due diligence has been ignored, there will be obvious consequences. Contrarily, funds that are more carefully managed will do better.

Many founders have survived the worst period in recent history, the pandemic. Now is the time to face another challenge. Use many of the same methods to get out the other side.

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