High hopes and a mountain of dry powder have VCs poised for a soft landing
Their wish came true earlier this year following a correction in the stock market. And despite the new climate of pressure on late-stage VC-backed valuations, there are plenty of reasons to expect the market to ride out the storm.
Stakes in pre-IPO companies that had their last financing event in the second half of 2021 are now trading at an average of 60% less than their previous round, according to Andrea Walne, a general partner at Manhattan Venture Partners, a secondaries-focused investment firm.
The management of Instacart, in an unusual move, cut its internal valuation by almost 40% in March. That aligned the grocery delivery company’s value more closely with key public market comparable DoorDash, whose stock has dropped nearly 50% over the past six months.
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These are steep discounts, implying that many late-stage companies are now significantly overvalued. Yet VCs, including some focused on the late-stage market, maintain that reduced pricing is necessary and even healthy.
Despite lower valuations and nearly closed IPO markets, investors are hopeful—at least for now—that their portfolio companies will have time to grow into their valuations.
Unless the stock market downturn drags significantly beyond this year, many privately held companies will likely be able to avoid much-dreaded down rounds, industry lingo for shares sold at a lower price than that of the previous financing round.
Investors say many companies that had a funding event last year have raised more cash than needed. These startups could curb their spending and try to make that capital last as long as possible.
Even in the event that a company requires a further cash infusion, they still have various tools at their disposal.
First, they could raise an extension round, selling shares at the same price as the most recent funding. Extension rounds were common at the start of the pandemic because they allowed investors to double down on promising companies at their existing price. And extensions will likely show up even more this year if startup valuations remain depressed.
Kyle Stanford, a venture capital analyst with PitchBook, said he expects more investor-friendly protections to make their way back into term sheets before a ton of down rounds occur. One such term: liquidation preferences guaranteeing that investors who are later entrants to the cap table will get paid before earlier investors in the event of an exit.
For now, these structures aren’t commonly seen on term sheets, investors say. But they could start popping up for the riskiest and most expensive deals. In the middle of the previous decade, deal terms for a good chunk of late-stage rounds, including mega-deals for Square and Box, came with ratchets. These helped investors become more comfortable paying a higher price because they knew their investment was protected from downsides.
But perhaps the biggest reason investors aren’t overly concerned about the possibility of their current portfolios being dramatically diminished in value is the unprecedented amount of capital in the system.
VC funds in the US have collected more than $70 billion in commitments in the first quarter of this year, according to PitchBook data. That’s already more than half of what was raised by the asset class during all of 2021, the highest year on record. It’s also larger than the combined funds committed in 2008, 2009 and 2010, the years of the global financial crisis. Investors will be eager to deploy these funds at more reasonably priced valuations.
Barring massive defaults by LPs, venture investors will have their coffers full for some time. PitchBook analysts estimate that this dry powder should last 2.5 to 3.5 years, a projection that excludes possible additional capital coming from nontraditional investors like mutual funds or corporate VCs, Stanford said. These funds will inevitably make their way to existing investments, not just new deals.
And presumably there won’t be a dramatic downturn in deal activity. Startups will continue to be funded, albeit with lower deal sizes and valuations.
To be sure, startup mortality rates are likely to increase in the near-term. The bar for raising Series A and Series B rounds has already increased, said Michael Kim, founder of Cendana Capital, a seed-focused fund-of-funds.
But even if the US economy goes into a mild recession toward the end of this year, there are reasons to believe venture capital can make it through the downturn relatively unscathed.
Adds Stanford: “I don’t think the industry could ask for better conditions than all the capital that’s available right now.”
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