The chasm between 2021 and 2022 involves much more than our collective response to Covid.
In their quest to secure financing, burgeoning businesses are running a gauntlet of challenges — from global supply-chain bottlenecks to cryptocurrency cratering to careening inflation numbers.
To see where we are now — and to understand why venture capital is undulating — let’s look at last year’s capital heyday and compare it with this year’s new realities.
VCs Set New Records Backing Startups in 2021
2021 was a record-setting year for VC firms and the startups they backed. With over $340 billion in deal value and more than 17,000 fundraising rounds, everyone focused on hockey stick revenue growth potential. (Pitchbook.) Almost daily, unicorns were created, and it was not unusual to see some achieve a $10 billion valuation.
Fueling the historic surge were three primary factors, as well as their interconnection:
Exits
Valuations
Interest rates
Exits
We all love profitable exits, but most of all, VCs love them. Lucrative departures help realize gains, bolster portfolios and plow returns into future investments.
Mergers and acquisitions, SPACs, private equity, and IPOs helped to drive more than 1,150 exits — on average more than three per day, including holidays and weekends. VCs were happy, founders loved it, and legal teams were busy.
Valuations
In 2021, VCs saw record gains of $600 billion—more than double the nearly $300 billion achieved in 2020 and almost four times greater than gains experienced in 2018. (Pitchbook.)
Interest rates
What fueled all this record activity and returns? Many argue that record-low interest rates created low-cost capital, which in turn gave investors the incentive to pursue equity.
Money poured into startups and established companies alike with the investment strategy of exploiting low-interest rates to capture and expand market share versus focusing on profitability.
It worked then, but will it continue to work now?
2022 Interest Rate Increases Change Everything
Rising interest rates create uncertainty, which tempers the frequency and valuations of exits. High-growth tech companies, especially publicly traded entities, are down drastically, dimming the luster of IPOs. Only 42 VC-backed companies have been listed this year, and almost all those listings occurred before interest rates rose. (Pitchbook.) (The Fed's four hikes so far in 2022 have increased rates by a combined 2.25 percentage points.)
In response, VCs are shifting investment strategies, recalibrating how they view valuations and what they’ll pay to achieve their performance goals. Rising interest rates foretell diminished profits from startups, making fundraising all the more difficult.
Shrinking valuations and increased fundraising difficulty are deeply intertwined. Crunchbase data on 2022 Q2 fundraising show the following key points:
There were $62.7 billion in deals, down 27% QoQ and 25% YoY.
Late-stage Q2 rounds were hit hardest, down 33% QoQ and 30% YoY.
Deal volume was down to 371 rounds, off 25% QoQ and 27% YoY.
Early stage rounds, farther from an exit, were hit less hard, down 15% QoQ and about 20% YoY to $23.1 billion in 1,015 rounds. (Pitchbook.)
With round counts and dollars deployed down, 2022 valuations are on track to be lower than those achieved in 2021.
Many high-profile VC firms have made it clear to their portfolio companies that valuations are changing. For example, A16Z told its PortCos to use public market multiples as a gauge of their valuations. With software stocks down 60% and fintech and consumer stocks down 70% to 80%, they probably took a similar hit assuming minimal revenue growth. (Future.)
Lightspeed Ventures and Y Combinator warn that the rest of 2022 (and probably 2023) will see an onerous fundraising environment, with the goalposts moved significantly. (Medium.) Sequoia concurs, saying that before a company could achieve a billion-dollar valuation with $10 million of annual recurring revenue (ARR) to raise a flat round, it would need $75 million to $100 million of ARR.
From Setbacks Come New Opportunities
While the changing fundraising environment in 2022 has created challenges for founders looking to grow their companies, it is also creating new opportunities. Just look at what emerged from the last financial correction: Venmo, Uber, Block, and WhatsApp.
With capital becoming scarcer, founders who can manage operating costs and capital burn rate will find it easier to grow—and grab market share in the process.
Some companies are struggling; others are taking advantage of the disruption. A note from Y Combinator suggests many other companies are simply unprepared:
“Remember that 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 by just staying alive.” (Tech Crunch.)
The result of this is that many premium expenses are costing less. Talent acquisition is one in particular. Market changes commonly result in staff cuts and layoffs by competitors, making it significantly easier and cheaper for younger companies to acquire top-tier talent. (Lightspeed.)
Now may be the best time to build up your engineering or sales and marketing teams rather than scaling back. But that’s your call—with the help of knowledgeable advisors, of course.
Using history as a guide, companies that maintain access to capital and manage costs typically succeed in environments like the current economic roller-coaster.
Looking for new ways to fundraise, fast?
If you're curious about capital solutions to grow your business so you can get a leg up on the competition—and you don't want to give up equity to do it—be sure check out our Guide To Startup Financing.