Michigan venture capital sees slowdown as an opportunity

To say the economy feels topsy-turvy is an understatement.

Inflation is running rampant and interest rates are soaring. Metro Detroit’s homegrown mortgage companies are increasingly squeezed as mortgage rates hit levels not seen since before the Great Recession.

Capital markets have been in retreat. Indeed, global M&A activity has fallen off a cliff, hitting its slowest period in a decade by at least one count.

And yet despite those rocky conditions, many businesses still see plenty of runway out there. And nowhere was that more evident than at Thursday’s Michigan Venture Capital Association annual dinner, the group’s 15th annual gala.

While celebrating 20 years of the MVCA’s existence, there were few signs of broader economic tumult.

About 175 venture capitalists, startup founders and others tied to the sector who were in attendance found a bar that was approaching top-shelf and plenty of opportunities to discuss potential deals.

Ask most any Michigan venture capitalist who attended the event at Greenfield Village about their level of current activity — and I did — and the response was consistent: “busy.”

But peel back one layer, and the reason becomes obvious: the venture capital market — the primary mechanism for financing emerging, high-growth tech companies — has gone through a shift in recent months.

Back in June, right as the economy was slowing, metro Detroit entrepreneur Sergio Rodriguez told me he envisioned the market flipping from favoring founders — who have been able to secure high valuations for their companies for years — and revert back to one in which VCs are in the driver’s seat.

That prophecy, at least to some extent, has been fulfilled.

For VCs — especially those who fundraised last year or early this year — that money now goes a lot further.

“You’re absolutely right,” one Michigan venture capitalist acknowledged to me during last night’s event when asked about their ability to get a better deal on their current investments than last year — or even years before that — when founders could command sky-high valuations.

And data backs that up, at least to an extent. The median pre-money valuation for an early-stage startup declined 16 percent quarter-over-quarter in the second quarter of this year, according to Pitchbook, the first drop in more than two years.

Companies with some level of traction — commonly referred to as seed stage — are faring better, according to the Pitchbook report, which found that the median pre-money valuation for such a company was up 33 percent this year when compared with last year.

2021 was, by most accounts, a high-water mark for the industry.

U.S. venture capitalists last year invested $329.9 billion across an estimated 17,054 deals, according to a year-end report from Pitchbook and the National Venture Capital Association. Some 730 U.S. VC funds last year raised a record $128.3 billion, a 47.5 percent year-over-year increase compared to 2020’s record of $86.9 billion, according to Pitchbook and the NVCA.

So given the record-setting year, yes, things have slowed by most accounts. But that’s probably for the best, said Erik Gordon, a finance professor at the University of Michigan’s Ross School of Business.

“I don’t think it’s so much that the VCs now have control,” Gordon said. “I think it’s more that it’s gone back to normal. The best-looking companies get higher valuations and the not-so-good-looking companies that are fundable get lower valuations.”

Put another way: The frothy days of 2021 when a web3 startup could command a $1 billion-plus valuation just because they said they were in the sector du jour are largely over.

Some level of “sanity” has returned to the marketplace, said one VC source.

And regardless of which party may have the upper hand at the negotiating table, that’s something to celebrate.