NAVIGATING THE WINDS OF CHANGE
As we navigate the ever-changing startup landscape, it’s crucial to stay updated on recent trends, particularly the decline in startup valuations. This blog explores the current state of startup funding, highlighting the decrease in valuations across certain stages of the startup life cycle and providing insights to the current fundraising environment for early-stage companies. We’ll also examine the reasons behind these changes and their impact on founders and investors. Despite these challenges, this shifting landscape also presents opportunities for innovation and growth.
THE PERIOD OF THE DOWN ROUND
Across the spectrum, we’ve seen median startup valuations dropping anywhere between 13% and 58% compared to the same time last year.[1] No stage of the startup life cycle has been immune, from the early birds to the late bloomers. Although valuations in the mid-to late stages have declined the most, early-stage companies experienced meaningful reductions in valuation as well. Series A valuations have dipped approximately 20% from $50 million to $39.6 million.[2] For those keeping an eye on the figures, it’s clear that we’ve entered the period of the down-round. Simply put, this is when a startup’s post-money valuation or valuation after an investment is less than the pre-money valuation of a company at a prior round. In Q1 alone, Carta has reported that the share of down-rounds as a percentage of all rounds in Q1 2022 is 3.6x higher than that in Q1 2022, an increase from 5.2% to 18.7%.[3]
Of course, this data reflects the few companies that were lucky to go through fundraising this past quarter. For startups that haven’t secured funding this quarter, there’s a similar story. Valuations are taking a hit as evidenced by the recent dip in 409a valuations. For those unfamiliar, startups typically conduct third-party appraisals of the company’s common stock on a per-share basis at least once a year. They’re crucial for startups issuing equity awards, with hefty penalties and tax consequences for those who stray off the path. With data suggesting that certain startup companies have opted to delay funding for fear of down-round valuations or being unable to conduct bridge rounds, 409a valuations could be a key indicator of a startup company’s performance.
So, what does the data say? The percentage of companies with stagnant 409a valuations has increased,[4] which may suggest that such companies have (i) delayed funding, (ii) cannot raise capital in the current environment or (iii) have wound-up and dissolved. Also, of the companies listed on Carta, option grant repricings (or pricing at a lower valuation) have increased 29% year-over-year.[5] These repricings typically occur when existing stock option grants become significantly “out of the money”, requiring adjustment to align with current market conditions and ensure employee retention.
Pre-money valuations for early stage companies for Series Seed and Series A companies increased by approximately 66% and 72%, respectively, from Q1 2020 to Q1 2022, while median pre-money valuations for Series B and Series C companies increased by approximately 89% and 100%, respectively, in that same time period.[6] The recent influx of down rounds suggests a market correction that has trickled down from the public markets to Series A and later financing rounds. In all, down-round periods should serve as a cautionary tale to founders accepting frothy valuations during over-heated markets that impact service providers and future financings rounds.
DECREASED DEAL VOLUME AND VENTURE DEBT SLOWDOWN
The current funding climate is characterized by a decrease in deal volume, with a 35% quarterly and 45% year-over-year decline in financings.[7] This impact is seen across all stages. Angel and seed financings have only seen $9.6 billion in deal value during the first quarter of this year, the lowest it has been since Q2 ‘20, and in the first quarter of 2023, only 19 late-stage deals with rounds of at least $100 million were recorded, compared to 98 such deals in Q1 2022.[8] Venture debt, too, has experienced a slowdown, with lenders exercising caution and the recent collapse of Silicon Valley Bank further limiting access to capital. This cautious approach stems from market volatility and the high-risk nature of startup investments.[9]
How did we get here? Certainly not for a lack of demand. According to Pitchbook, the demand for venture financings for late-stage companies has reached a decade high when demand is now 3.24x that of capital supply.[10] Although not as drastic, early-stage companies have seen an increase in demand exceeding the amount of venture capital supply (at approximately 16%).[11] A lack of investor confidence and market uncertainty have contributed to the slowdown.
INVESTOR CONFIDENCE AND SHIFTING IPO LANDSCAPE
Investor confidence has reached recent lows due to concerns of an impending recession, regional banking failures, and high inflation rates. Rising interest rates have led to lower risk-free rates, subsequently impacting the valuation of startups when using discounted cash flow models. The emphasis on revenue, margins, and cost efficiencies in today’s IPO market further complicates matters for late-stage companies, as historically IPOs focused more on growth and less on profitability. Founders are reluctant to raise new priced equity rounds, fearing down-round scenarios that signal a loss of momentum to the market and dilute equity for existing investors. Consequently, bridge rounds have increased across Series A to Series C companies, providing short-term solutions to long-term funding challenges.
While bridge financings address companies’ needs today, they provide a short-term solution to a longer-term problem. Founders also recognize that the current fundraising climate favors investors; non-standard deal terms such as higher relative liquidation preferences and participating preferred stock have increased year over year.
Another variable in this equation are the venture capital funds. Per Pitchbook, approximately $158.5 billion in capital commitments were raised in 2021 alone and $170.8 billion in 2022.[12] Pitchbook estimates that $289 billion of dry powder was raised at 2022 year-end.[13] The Mayfield Fund alone raised a fund this year of just under $1 billion with a focus on backing Series Seed, Series A and Series B companies.[14]
Venture capital funds need to put this money to work as they have a duty to their LPs to seek attractive investment opportunities that generate a high enough ROI to justify the typical 20% takeaway in profits. Further, the sophisticated venture capital investor takes a long-term investment approach, with firms exiting their investments and liquidating their funds after seven years or so. Sure, VC firms have contingencies to provide follow-on investments to their portfolio companies, either for those performing per expectations or those facing a downturn in immediate need of funds. However, this allocation isn’t part of their primary investment strategy, which is to use a majority of their funds for net-new investments during the first three to five years of the fund’s life.
While the current fundraising climate presents challenges, it also offers opportunities for innovation and emergence in the market. Venture capital funds hold substantial capital commitments, and despite the decrease in deal flow and valuations, they continue to seek attractive investment opportunities. With the right balance of caution and courage, founders can navigate these challenges and strive for success. After all, in times of adversity, the most innovative ideas often emerge.
[2] Q1 2023 Pitchbook-NVCA Venture Monitor. (2023). Pitchbook Data, Inc. Retrieved from https://pitchbook.com/news/reports/q1-2023-pitchbook-nvca-venture-monitor.
[3] Wilhelm, A. (2023, April 3). Down rounds are prevailing as power shifts to VCs again. Retrieved from https://techcrunch.com/2023/05/03/down-rounds-are-prevailing-as-power-shifts-to-vcs-again/.
[4] See footnote 1.
[5] See footnote 1.
[6] Dowd, K., & Walker, P. (2023, February 10). State of Markets: Q1 2023. Retrieved from https://carta.com/blog/state-of-private-markets-q4-2022/.
[7] See footnote 1.
[8] See footnote 2.
[9] See fn. 1; Brewster, L. (2023, April 17). With the collapse of SVB, venture debt is drying up. Retrieved from https://fortune.com/2023/04/17/with-the-collapse-of-svb-venture-debt-is-drying-up/; Sonnenberg, J. A. (2023, March 2). Investors prefer debt over equity (but not venture debt). Retrieved from https://techcrunch.com/2023/04/18/investors-prefer-debt-over-equity-but-not-venture-debt/.
[10] See footnote 2.
[11] See footnote 2.
[12] See footnote 2.
[13] See footnote 2.
[14] Mascarenhas, N. (2023, April 1). Mayfield raised just shy of $1B to avoid unicorn hype. Retrieved from https://techcrunch.com/2023/05/08/mayfield-new-fund-xvii/.
