Venture Capital

Shifting Tides: Assessing the Post-"Everything Bubble" VC Environment in 2023

April 26, 2023

2022 was the year the "Everything Bubble" fueled by easy monetary policy finally popped. The mania in private and public markets from 2020 to early 2022 was rivaled only by the Dot Com boom of the late 1990s. Over the last few quarters, the bill for all that fun has come due in the form of rising inflation, with a Federal Reserve now willing to do whatever it takes, for as long as it takes, to curb the inflationary trend in hopes of a soft landing. 

Investors and casual observers alike are now guessing at what the rest of 2023 has in store, with predictions that run the gamut i.e., will the economy tailspin into a recession, drift into a soft landing, or experience a rapid positive reversal. EQUIAM is a systematic and data-driven investor in the growth and late stage private markets so, instead of a crystal ball, we look to our GENIUS model to help assess the probability of each potential outcome. 

Thinning of the Unicorn Herd 

Globally, there currently are nearly 1,200 “unicorn” companies with valuations of $1 billion or more. The majority of these companies achieved unicorn status between 2019 and 2022. Based on insights from our models, we estimate that over 250 of them will lose their unicorn status by the end of 2023, with a few at the low-end likely to enter bankruptcy. For example, over 66% of the unicorns in our model have an enterprise value-to-revenue ratio that is greater than 20x. When benchmarked against public company peers, these companies are vastly overvalued (even after adjusting for growth), and will likely find it difficult to raise capital from a more skeptical and weary venture capital community. 

However, despite positional weaknesses, the defenestration of unicorns will be lower than expected due to cash preservation and layoff strategies implemented by companies in 2022, as well as the large volume of mega rounds raised by companies in 2020 and 2021. 

Down rounds Finally Make an Appearance

Companies that sought funding through share issuances in 2022 generally did so at flat valuations. While some companies appear at first glance to have raised capital at high valuations, a closer examination reveals that those “up rounds” were largely illusory, with share issuances actually coupled with additional concessions such as warrants, increased PIKs, or other similar “deal sweeteners”. Currently, nearly 25% of the companies ranked by our GENIUS model have less than six months of estimated runway with 80% of them having raised capital in the height of 2020 and 2021 fundraising mania cycle. As the saying goes, when the tide goes out it becomes apparent who has been swimming naked. If the current incremental growth environment persists, a good number of companies will be forced to raise capital at lower valuations from their prior funding rounds. 

SVB Collapse and Its Ramifications

The sudden and dizzying collapse of SVB left many in the VC ecosystem scrambling for answers and solutions in its immediate aftermath. Now that some of the dust has settled, the question is: who is going to step in to fill SVB’s shoes in venture lending. The answer so far is a resounding “no one”. Venture debt is drying up and down to $3.5 billion in deal activity through Q1 2023 a sharp and marked decline from the $34 billion in 2022. With banks by and large shying from venture lending, other alternative lenders and private non-bank lenders are jumping in to fill the hole. These new sources of lending come at a sharp price with much higher interest rates, 5%- 10% more, than what SVB was lending out at.  The net result is a higher cost of capital and bigger cash crunch for startups, which will likely lead to more distressed companies. There are a number of companies in the VC ecosystem currently that will have no other choice but to accept these new terms as a matter of survival. 

M&A Makes a Comeback

Bear markets have historically presented different drivers for M&A activity, with the rationale shifting toward reconfiguring cost structures and building scale or profitability to weather the storm. For example, embattled companies may seek out mergers in order to better compete in a less-crowded field. Two sectors we believed to be particularly primed for M&A actively are Fintech and Foodtech/Delivery. 

Over the last two years, Fintech was a leading sector for venture investment, with over $125 billion raised by startups in the space. We believe that financing activity in the space will continue in 2023. There are over 150 Fintech companies in EQUIAM’s GENIUS model, including numerous neobanks, lending companies, and fintech infrastructure firms. Anecdotally, one such company, Chime, made two offers to purchase DailyPay last year but was rebuffed. We believe that, as Fintech companies find themselves fighting over the same customer base, consolidation will provide an attractive means to help decrease cost structure and increase profitability. Fintech remains one of the most overvalued sectors in our private company universe and M&A may be the only way some of these companies can survive. 

No sector benefited more from COVID tailwinds than online grocery and food delivery. Among others, GoPuff, Instacart, Getir, and Weee! raised megarounds and grew like weeds to meet the demand. In the wake of the COVID surge, the market has now come crashing down with many investors realizing that the economics just don’t add up. With valuations down from their former stratospheric levels (from 20.0x+ to less than 5.0x EV/Revenue), some strategic acquirers may find it beneficial to tack on high growth delivery to legacy slow growth brick and mortar offerings.  

The Layoffs Will Continue Until Morale Improves

Based on extensive hiring data tracked by our GENIUS model, VC-backed company employment peaked in July 2022. Since then, we’ve seen the largest cohort of companies lay off 14% of their employees. Nearly two-thirds of the companies in our GENIUS model are still unprofitable on a EBITDA basis. Human capital is the largest cost bucket for startups and layoffs, while bad for employees, are good for business. Technology companies that over-hired during better market conditions will come to the realization that they can garner the same level of revenue with a smaller workforce. For example, Salesforce found that nearly all of its annual contract value was being delivered by 50% of sales account executives. We anticipate that many other companies will come to similar realizations. Based on data tracking headcount, and financial and cost structures, another 20%-30% headcount reduction will likely be necessary for these unprofitable companies to survive and thrive.

2023: The Defining Year for AI

The year 2023 has been dubbed the 'Year of AI', and for good reason. Artificial Intelligence (AI) has reached a tipping point, permeating every aspect of our lives and revolutionizing various industries. From healthcare and education to transportation and entertainment, AI has become an indispensable tool that continues to push the boundaries of human innovation. Breakthroughs in algorithms and generative AI, particularly in deep learning and reinforcement learning, have enabled AI to not only recognize patterns but also to learn from experience and make intelligent decisions. This is in addition to the enhanced computational capabilities and exponential growth in computational power and the access to vast amounts of data to train better and more accurate models. Data is the lifeblood of AI, and the digital revolution has provided an unprecedented amount of data for AI systems to learn from across various domains.

All of the above has led to more widespread adoption and democratization of AI tools. As AI becomes more accessible and user-friendly, businesses and individuals alike can harness its power without needing advanced technical expertise. People are using ChatGPT and other Generative AI products to code, write articles and marketing copy, and diagnose patients. In 2023, AI's ability to analyze and process vast amounts of data enables hyper-personalization across a range of applications. From tailored recommendations on streaming platforms to personalized medicine in healthcare, AI-driven personalization has become an expectation rather than a luxury. The integration of AI into the workplace has accelerated in 2023, with AI-powered tools enhancing productivity, collaboration, and decision-making. As AI systems continue to improve, they are increasingly capable of taking over repetitive and mundane tasks, allowing human workers to focus on more creative and strategic endeavors.

With all the promise of AI, VCs continue to step up and scramble to get in on the next wave of technology advancement. Funding for Generative AI has gone from ~$900 million in 2018 to nearly $6.0 billion in 2022 and the pace of deal-making has continued into 2023. OpenAI, Anthropic, Adept AI and Jasper are just a few of the hundreds of companies raising rounds to build the next wave of generative AI solutions.  

This above paragraph was written by and brought to you by ChatGPT. 

Secondary Markets More Important Than Ever

The IPO market remains in a deep freeze (>80% drop in IPOs from 2022 vs. 2021) and experts warn that a thaw is not likely until the second half of 2023. The secondary markets for private shares have come to the rescue, providing early investors, founders and employees with access to liquidity. The market for direct secondaries in venture-backed companies outside of cap-table-to-cap-table transactions is quietly growing behind closed doors, from $35 billion in 2020 to an estimated $85 billion in 2023. EQUIAM maintains a comprehensive dataset on secondary trading volume in private markets and at the height of the recent boom, there were six bids for every offer but as the market cooled in 2022 we’ve seen the inverse ratio with five offers for every bid. We are beginning to see signs of movement towards an equilibrium in the market with buyers and sellers meeting in the middle. EQUIAM has taken advantage of disequilibrium to take positions in our portfolio at large discounts to last funding rounds. Other investors are likely to follow suit in the first half of 2023. 

Arin Nazarian

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