Venture Capital

Where does venture capital go now?

May 6, 2022

Fear in the public and private markets is being driven by three core market factors: inflation, economic fallout from Ukraine, and an expectation that the U.S. Federal Reserve will continue to raise interest rates. For venture-backed private companies, valuations have come down from the highs of 2021 and founders can now expect tougher terms from investors, or more aggressive deal terms, such as higher liquidation preferences, participating preferred stock, and anti-dilution clauses. Many IPOs will be delayed, especially for companies without the fundamentals to back their valuations.

Pushing against these headwinds is $500 billion of dry powder in the venture capital ecosystem. Investors who are trying to navigate this uncertainty should keep an eye on the following important factors:

1. Inflation

Inflation is eating the world right now and that includes investments. Investors are increasingly forced to allocate to high growth to avoid losing money. The Fed’s necessary response — raising interest rates — historically has not been a friend to growth either but we may be in the midst of peak near-term inflation. If the Fed is successful in reversing the upward trend and the economy avoids recession, keep an eye on VC funding flows. They may pick up along with exits in the second half of the year and early next year.

2. Secondary market prices (Hint: Say goodbye to the insulation myth)

Once upon a time, VC claimed to be insulated from public market volatility, in part because prices were hidden between funding rounds. Now, investors don’t have to wait. We saw the public market correction in February and March echo right through the vibrant secondary market for venture-backed equities. EQUIAM lowered bids up to 50% in December and January. There was initially some hesitation on the part of sellers, but by February, attitudes had changed. Secondary market prices now show a significant drop in multiples on revenue.

3. An IPO thaw?

Amidst a Q1 slowdown in IPO velocity, founders and their backers are wondering how long they will need to wait for an exit. Unicorns that have been discussing an IPO since last year, such as Stripe and Reddit, may push hard for 2022. For everyone else, it’s a game of waiting for clear signs of a sustained market recovery. Again, watch for more activity in the second half of the year, especially if we see slowing inflation and a successful breakout IPO. Newly public companies with strong fundamentals may look like deals compared to frothy 2021 valuations.

4. Cash on hand and revenue growth

Founders who grew up in the issuer friendly venture market of the past decade face an unfamiliar reality: lower valuations and demands from investors that they may not have seen before. In this environment, a strong cash position, robust revenue growth, and a clear path to near term profitability are critical metrics for issuers to possess. Those rare companies with superb growth metrics, strong top-line and bottom-line growth, and most importantly, a valuation that is in-line with comparable public market valuations should find willing investors. On the other hand, less impressive firms may be forced to slash valuations, accept onerous funding terms, and potentially raise the dreaded “down round”.

There are still attractive growth deals in the market, but investors should approach high profile private company allocations with caution. EQUIAM’s path to risk minimization involves the use of data-powered, systematic investing to sift through thousands of possible target companies and millions of data points to identify the strongest companies and identify appropriate valuations. While most investors may not have access to the expertise, systems, and computational tools necessary to implement a full-scale data analysis, they should at least shift their investment priority from top-line growth to balance sheet strength and bottom-line health.

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