Investing in a Market Downturn
In a market where conditions are constantly changing, it can be challenging to keep up with trends and then adjust your diligence and fundraising strategies based on those trends.
VCs & angel investors spend a lot of time thinking about how to invest in a market downturn particularly in early stage investing.
Guest speaker, Jordan Sawadogo has operator experience navigating the 2020 downturn. Last year he evaluated over 700 startups at 500 Global and led 7 early stage deals.
In this discussion, Jordan walks through topics including market trends, round dynamics, diligence and fundraising tips.
US Deal Activity Slides for Four Consecutive Quarters
For the first time in about 7 years, we have seen four consecutive slides in deal count activity based on data from Pitchbook. The graph above, focused on the US venture scene and segmented by different stages, is a combination of both deal count and deal value on a quarter by quarter basis across the years from 2017-2022
The first aspect that stands out is the velocity in the drop in deal count and many VCs have experienced this anecdotally. We’ve seen and heard that firms are slowing down. This chart really paints a picture of the magnitude of that pullback.
We also see that deal value has been a bit more resilient. According to this graph, it has dropped 50% year over year basis but not to the same degree of deal count. We see this bifurcation where there are a handful of companies that are outlier performers. A small percentage of companies are still able to attract a ton of capital and outsized rounds. 95% of other startups that are just facing significantly more difficult market conditions.
Angel & Seed – Fewer Deals at Higher Values
As we zoom into the angel and seed space, we see fewer deals with higher valuations.
The above graph from Pitchbook is showing deal count by deal value. Deal count saw an aggressive 50% drop year over year. Deal value is also dropping but not quite to the same degree as deal count.
As we start to think about how these rounds are coming together and what the typical round values are, we see a split by the quality of a company. This next graph depicts the average value for an angel deal:
- Light blue: average value for an angel deal
- Yellow: Median deal value for angel deal
- Dark Teal: 75th percentile for angel deal
- Black: 25th percentile for angel deal
Most of these trends are seeing either flat for slightly smaller deal values on the angel side, with the exception that the average is increasing. From that, we can conclude there are a handful of companies that are still attracting larger angel rounds.
When looking at the seed deal values, we see a bit of a different behavior. The graph above shows all tiers of companies are actually seeing a higher seed value, about 23% higher rounds, year over year. The average has increased from 4.2 to 5 million.
One reason we are seeing higher seed values on the round size is because Series A investors are taking longer to get comfortable with this new normal. As deal count is decreasing, firms are becoming less active. This means that for those at the seed and pre-seed level, there is a higher bar they need to meet. Investors may be taking longer due diligence periods, asking tougher questions, etc. This is translating into much longer times for fundraising for everyone.
The average time between rounds is now 24+ Months.
In the graph above from Carta, we see that fundraising is taking anywhere from 1-3 years based on the tier of company.
If we take a look at overall trends, you will see in all stages this elongation of average round size. No stage is really immune, whether you are a top flier or the average, things are just taking longer.
Most companies that we speak to are often operating on burn rates that are legacies of 2021 or capital that was quite cheap. Companies did not fundraise with these timelines in mind. We are now telling founders to either have a plan that meets this new normal for fundraising time or go out to market and construct your next round knowing that it might take 24 plus months to close.
The Bar to Close is Higher across all Early Stage
On the pre-seed side, we are seeing valuations down 40% YoY. In 2021 and 2022 companies were raising 30-50 million post money pre-seed valuations. It was such a departure from fundamental valuations, so that’s starting to be reset.
At the same time, the amount of capital that companies are raising doesn’t buy them the same kind of dilution. We’re seeing about a 25% increase on the amount of equity that founders need to sell at the pre seed stage to get investors over that hump. As we mentioned before, due diligence is taking longer.
Lastly, we see the bar rising. Companies can still get away with pre revenue, but we’re seeing more and more companies that are testing the revenue models earlier. Founders and angels that are doing deals at the pre-revenue or pre-seed stage. Keep in mind that this bar will continue to rise and there will continue to be pressure to generate revenue even at the pre-seed stage.
Seed deals are moving in the same direction as pre-seed with decreasing post-money valuations and increasing dilution. Investors are expecting founders to give up to 30% of their equity for the seed round. Since there is an increased expectation for generating revenue at the pre-seed, it’s almost impossible now to do no revenue deals at the seed stage.
Series A has probably seen the most movement in terms of the bar. Post money valuation has dropped while dilution has increased, asking founders to sell 20-30% of the company at this stage.
Two components investors and founders should be aware of is the increase in diligence and the revenue requirements. Diligence can now take up to 6 months, sometimes longer. Revenue targets continue to reach upwards. This is the normal we are seeing today, but these bars will continue to change.
Close to $300Bn Dry Powder is sitting on the sidelines.
According to Pitchbook’s report, there is $300Bn of dry powder that has been accumulated during the pandemic and is now sitting on the sidelines. The main question is, when will this capital be deployed? Will it be deployed into the late stage or early stage companies? Will it be more aggressive as valuations drop? There is a lot of uncertainty in terms of behavior of this dry powder.
In Past Downturns, Dry Powder Waits out the Rain
This report by SVB does a great job of quantifying the vintage of dry powder during the downturn.
These blue curves represent dry powder by vintage. The light blue curve represents vintages of two years and older. The middle blue curve represents vintages of three years and older. And then this dark blue curve represents vintages that are four years or older.
The way that you interpret this graph is to look at the accumulation of dry powder in recessionary environments. During the .com bust we see that the dry powder that was at least four vintages or older increased dramatically from 10% to 35%. Meaning, all 25% of all capital in 2004 was from funds that were at least 4 vintages old.
People pulled back in past downturns and a lot of this capital sat on the sidelines. The good news is that when conditions improved, that deployment worked its way back into the market over a span of a couple of years.
While history may not necessarily repeat itself, there is precedent that past cycles are an indication of what is to come. There is precedent for dry powder to continue to sit out on the sidelines.
60% of Dry powder was raised in the last 2 years
While this may not be the most optimistic message, there is a silver lining.
“You cannot overtake 15 cars in sunny weather… but you can when its raining” – Ayrton Senna
It is a lot easier to overtake your competition in a tough market than it is in a market where everyone is succeeding. When capital is cheap and easily available, businesses don’t have the same kind of scrutiny. It is easy to grow when capital is easily available.
But when that capital dries up, the companies that are strong operators are going to be the ones that navigate and outmaneuver the competition.
In conclusion, deal activity continues to fall to pre-pandemic levels. The bar is higher across all early stage companies and due diligence is taking longer. Market conditions are constantly changing. It is important to stay close to those who can give you strong market intel and see what the market is doing in terms of the bar so that you are capitalizing your companies in a way that gives them a fair chance of reaching their milestone. The silver lining is that talented operators can thrive in a market downturn. Spend the time asking the right questions to seek out talented operators.
There are 2 main topics to discuss when it comes to diligence: teams and business models.
“If a rising tide lifts all ships, then choppy waters rock all boats”
No team is immune to the pressures of a downturn. Down markets challenge companies and teams in new ways. We encourage our team to ask questions that will help us understand the team’s ability to weather these choppy waters.
A few things we analyze to help determine if we are backing the right team:
- Stress test founding team’s relationship
- Ask co-founders about the weaknesses or improvements of other co-founder.
- Backchannel reference calls
- Can those references speak to times when co-founders had to overcome challenges and adversity?
- What is their support system?
- We’ve even seen founders who have left the game because the market was just so tough. Who do founders have in their camp and can help pick them up when they are down?
- How do they evaluate trade-offs?
- Founders are being asked to do more with less, which means you’re going to have to make difficult decisions.
- Understand their “why”
- Are they doing this for reasons that will allow them to endure in some tough times?
People are looking at business models in a new light. Some of the things that we see:
- Relative Market Attractiveness
- In today’s market, we know that the appetite for downstream capital simply is not there. Even if we liked the team and we like what they’re building, we see the capital formation as a huge risk.
- Quality of Revenue
- How did the founder win that deal? Evaluate where the company’s revenue is coming from (warm lead, cold outreach, switched from competitor, etc.)
- Durability of Partnerships
- There has been a lot of turnover especially among senior staff at publicly traded companies. On the B2B side, how heavily do companies rely on these partnerships and what will be the outcome if one of these partners leaves their company?
- Time to Value / Burn Multiples
Relationships matter more than ever. We are telling everyone, start early and communicate often. Investors are expecting this from founders and want time to generate relationships. Have more conversations with investors and start those conversations earlier in the round. The earlier founders can initiate the conversation, the earlier they get credit for all of the progress they make after that initial conversation.
After building that trust, founders can switch the conversation to more of a fundraising mode and capitalize on that goodwill. One of the worst things founders can do right now is to bet that they are the exception.
Embrace the reality of the market and be flexible with dilution. Understand that flexibility comes with upside and if you can get through this period, you may be the only game in town.
For both investors and founders, the sooner you can adapt to this new normal, the more resilient you’ll be and in a better position on the other side of this downturn.