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I have been witness to a great many ups and downs in the markets — including a number of seismic events — and in the process have developed a bit of a déjà vu response when it comes to cycles and bubbles, not least in the realm of starting a business.
I began my formal Wall Street career in the investment banking group at Bear Stearns in 1992, however, as early as 1987 (while still in high school), I worked for two summers as a specialist clerk “making markets” in Walt Disney and other equity options. Among the events I’ve witnessed since were the crash of ’87, the Netscape IPO in 1995, and numerous companies at the time paying for eyeballs to achieve unsustainable valuations. Then there was the 1998 Russian financial crisis and the Nasdaq and dotcom bust in 2000. Then came Madoff in 2008 and the subsequent years’ many sector bubbles (from biofuels to biotech) and now crypto and other things I frankly don’t really understand well . I’ve learned about all this time that cycles are just that: they repeat and rhyme, with main characters simply changing their names.
There is currently a massive need for funding among venture-backed start-ups, but the fundraising environment has never been more challenging. The Fed has opened an airlock; we can all hear a massive whooshing sound of money being sucked out of the system, and this will severely impact venture-backed companies and their ability to raise capital to stay alive. Most of them, along with their founders, are still a bit “deer in the headlights” in response — struggling to accept the new valuation landscape. As the world was flooded with liquidity in 2020 to 2021, we witnessed giddy times for start-ups raising capital, whether Series Seed, A, B or C companies. We saw many in the Series B category being paid inflated Series D or pre-IPO prices by mega crossover hedge funds that were trying to leapfrog and lock up deals prior to an IPO. Today, things have changed: New capital is in short supply, and it will be harder than ever to fundraise. Because of that, we will see many wind-downs, unfortunately, of some potentially great start-ups that simply run out of fuel. Most venture funds are now in slow-play mode — more focused on their existing portfolio and keeping their winners alive.
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So, based on past cycles and various myths I have heard recently, some guidance:
My advice to founders is to raise money now if it is available to you. Do not wait for things to improve because companies seeking capital will have even more competition in 2023 and need to accept this new reality. It may be a lower valuation or more draconian deal terms like 2x liquidation preference or warrants, but a bird in the hand is always the best course of action in an uncertain environment. Early-stage start-ups will not be as pressured as later-stage growth round enterprises (ie, post-Series C companies), which may have raised capital at valuations not reflective of where things are today and will see more highly structured or down rounds.
Myth: 2023 Will Be a Better Fundraising Environment, Including Better Terms
Possible but unlikely. The challenge with this argument is that there will be so much pent-up demand and competition for new capital from other start-ups that it will be a buyers’ market and there won’t be sufficient capital to fund all companies.
Imagine New York’s LaGuardia airport on a winter weekday night at 10 pm It has been snowing all day and the airport has been closed due to weather. There are hundreds of planes waiting to land on limited runways and no chance they all get in before LGA closes at midnight. That is what we are seeing now, and it will get worse, because funding will be much more limited and expensive in 2023. In challenging times like this, term sheets are going to change from “plain vanilla” to much more structured and investor-friendly deals. Founders may encounter things they haven’t seen in a long time, like warrants and full-ratchet anti-dilution provisions.
Prepare to be surprised.
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Myth: There is Ample Dry Powder on the Sidelines
True, but this was also true in 2008 when LPs told their PE or VC fund that if they issued them a capital call, they would never re-up for future funds. It worked. All that dry powder which was supposedly on the sidelines was all on a string. (For example, a statement like, “Yes, I committed capital to you, and you have dry powder, but don’t ask me for it!”)
While many venture funds have raised new funds which are 2020 or 2021 vintage years and are actively making new investments, many are making hard decisions about which among their existing portfolio companies to support, and are also working at putting out fires. New investment activity will suffer, and we are seeing a period of what I would call “slow play,” with a lot of tire-kicking and reluctance to act quickly. Gone are the days of companies receiving multiple term sheets on the same day and rounds filling up quickly. There will be longer diligence periods, and we will even see funds back away from issued term sheets. This is the new norm.
Myth: Valuations and Multiples will Rebound
There is an old expression: Stocks go up on an escalator and down on an elevator. Some multiples will not rebound anytime soon to the peaks we saw in 2021 and may take years to do so, if ever. The liquidity-fueled tsunami caused the pendulum to swing hard to one side; it could well overcorrect to the other, and may take a long time to find the median.
Related: The Art (And Science) Of Valuation: Here’s How Venture Capitalists Value Your Startup
So, if you are seeking capital, my advice is to start early and plan for a long, slow process. You will need to kiss a lot of frogs before finding your prince. Have low expectations when it comes to terms, and know that every dollar raised will be a hard-fought battle.
Don’t be bashful about raising funds in smaller increments and with multiple closes. Also, be frugal with spend and be prepared to tell your story many times over. Good ideas and founders will make it, but, with the hot money now gone from the playing field, Darwin will rule the day and only the best will be allocated capital. It’s also important to realize that the venture industry focus has shifted to near-term profitability vs. growth, and so most companies are working to reduce costs and extend cash runways.
The landscape will always have the “haves” and “have nots,” and we are going to see many down rounds coming for those companies that do not have the funding to get through 2023.