Q1 2022 Quarterly VC Update: Matt Sacks on the State of Venture Capital Investing

In conjunction with our Q1 Venture Financing Report, I sat down with Matt Sacks of Lightbank to get his take on the state of venture capital investing.

Key insights from Matt Sacks

On the future of the Midwest’s innovation ecosystem: “Over the past decade, the size of the venture capital industry has expanded at a remarkable pace. … We believe there is a tremendous opportunity to be a capital provider to the early-stage innovation ecosystem in the Midwest and help this market develop.”

On disruptive technology trends in the Midwest: “[W]e find that the Midwest ecosystem generates a significant number of exciting startups attempting to disrupt categories like steel manufacturing and commodities trading.”

On the growth of Chicago’s VC market: “To truly achieve scale, a startup ecosystem needs to nurture an appetite for risk and acceptance of failure, have great research institutions and strong engineering talent pools, have a series of successful prior-generation companies that created significant value for those involved, and importantly, have enough early-stage capital providers willing to embrace risk.”

Before Lightbank, you were a technology investor at NEA in New York. What brought you to Lightbank and guided you to pursue a career focused on Midwest investing? What excites you the most about the Chicago VC market?

Over the past decade, the size of the venture capital industry has expanded at a remarkable pace. As a result, there has been a substantial amount of capital available to fund early-stage business ideas. The Midwest is one of a few geographies we have observed that still does not have enough capital to fund all of the great entrepreneurs pursuing big, ambitious startup opportunities.

The Midwest has a high concentration of Fortune 500 businesses, world-class research institutions and an incredible depth of engineering talent. According to PitchBook data from 2006 to Q3 2020, Chicago generated the highest median VC exit multiple of any US city, outpacing second-place New York by 26%. The Midwest comprises approximately 16% of the US GDP, but only 4% to 5% of dollars raised by venture funds and venture capital invested into startups (2021 data from the National Venture Capital Association, PitchBook and the US Bureau of Economic Analysis).

We believe there is a tremendous opportunity to be a capital provider to the early-stage innovation ecosystem in the Midwest and help this market develop.

Our data shows that the large Q1 2022 numbers for deal volume and invested capital are boosted by record numbers of deals and invested capital in technology companies. Are you seeing similar activity in Chicago, and are there any subsectors of disruptive technology that you see driving this activity?

Technology is no longer its own industry – it is redefining every industry. We believe that over the coming decades, that which has existed offline will exist online. This central thesis grounds our thinking when assessing digital opportunities. We especially like investing in markets with limited technology penetration, undergoing significant disruption, and that are growing rapidly.

Given its proximity to old-line industry, we find that the Midwest ecosystem generates a significant number of exciting startups attempting to disrupt categories like steel manufacturing and commodities trading. These traditional industries still often run their businesses with spreadsheets, clipboards, pencils and paper. Building vertical software or marketplaces (or both) to bring giant industries online is a trend we will continue to pursue.

We have also seen a significant number of interesting startups emerge in categories like fintech and climate tech. That being said, we are not focused on any subsector or specific opportunity set, as we see technology impacting every sector.

Chicago’s venture capital market has been steadily growing for the past decade and has most recently seen the ascension of several unicorn companies. What are the biggest drivers propelling the growth of this market? How will this trend impact the coastal VC markets?

Startup ecosystems take time to mature. Silicon Valley has developed over half a century. To truly achieve scale, a startup ecosystem needs to nurture an appetite for risk and acceptance of failure, have great research institutions and strong engineering talent pools, have a series of successful prior-generation companies that created significant value for those involved, and importantly, have enough early-stage capital providers willing to embrace risk. There is a great book that came out earlier this year – “The Power Law: Venture Capital and the Making of the New Future” by Sebastian Mallaby – in which the central thesis is that venture capital was a (or the) critical ingredient to Silicon Valley’s emergence. That is the opportunity we are trying to pursue in the Midwest – to help concentrate capital in a manner that drives a virtuous cycle and helps the ecosystem mature.

Historically, Chicago has been known as a major hub for business, infrastructure, transportation and logistics, but given its recent climb into the venture capital ecosystem, are there any new emerging verticals investors should be aware of?

As I mentioned earlier, technology is no longer its own sector – it is the base layer underpinning of every sector. There are exciting businesses being built in Chicago across many sectors. Klover is a Chicago company we partnered with last year. Klover offers low-cost financial products to consumers in exchange for monetizing their most valuable underutilized resource: their data. The company is one of the fastest-growing businesses we have ever worked with. Showrunner is another company we partnered with. Showrunner builds software for the film production industry. Showrunner actually just moved to Chicago from New York because the team believed the environment to build was better here. We believe there will be significant opportunities to support world-class teams building disruptive solutions in many verticals.

In Q1, we saw a slight dip in ‘up’ rounds from the record high of 99% in Q4. Given some of the uncertainty in the public and private markets, do you anticipate that these numbers will continue trending down?

The past decade, and the past several years in particular, have resulted in one of the best-performing venture markets ever. The public equity market sell-off and diminished IPO market of the past six months should have an impact on the venture market, at a minimum in terms of valuations. Like investors in the public markets, venture investors on the margin have shifted their focus from growth at all costs to measured growth with good margins, and are driving harder bargains on valuation. This has a larger impact on the later-stage venture and growth investors than it does on early-stage pre-seed, seed and A round investors like us. For early-stage businesses, it does place a higher premium on having a longer runway that enables management companies to focus on building without the pressure of returning to market as frequently as they would have in the more robust markets of a few quarters ago.

For those companies that raised capital at 30, 50, 100x annual recurring revenue (ARR) or even higher multiples, they are going to have their work cut out for them to grow into their valuations before their next financings, or they will have to consider structured financing or raise at a down round. While that is never fun, we do believe that quality companies with good business models attacking large total addressable markets (TAMs) will do well over time – interim valuation pressure aside.

Given the early stage that we invest at and the time horizon that requires, we try not to let swings in market value drive our investment decisions. We continue to meet world-class founders with ambitious visions to solve real-world problems, and we continue to see portfolio companies generate significant top-line revenue growth, with strong unit economics. That combined with a sensible burn rate is a recipe for success in any market, and we are bullish about the opportunity in front of us.

Any other observations on this quarter’s VC data worth noting?

We expect the slight dip in the Q1 data to accelerate in Q2. We believe the Q2 data will paint a darker picture of the financing environment, and we have been spending time with all of the companies in our portfolio with that perspective in mind. Startups should focus on revenue growth relative to burn rate, securing sufficient runway (18 to 24 months in most cases, but it can vary), and generating high gross margins, profitable unit economics and short customer acquisition cost (CAC) payback periods. For the companies that fit that mold, the next couple of quarters will provide an incredible opportunity to put their heads down and build.

About Matt Sacks

Matt is the co-managing partner of Lightbank. He also is the co-founder and executive chairman of Luminary Media, a subscription podcast network with original shows from creators such as Dave Chappelle, Lena Dunham and Russell Brand. Previously, Matt was a technology investor at NEA, and a member of the technology, media and telecom investment banking team at Goldman Sachs. Matt also interned at First Round Capital and helped to launch Splash.FM, a social network for music sharing and discovery. He graduated magna cum laude from the University of Pennsylvania, where he earned a BA in history.

About Lightbank

Founded in 2010, Lightbank is a venture capital firm based in Chicago. The firm specializes in making early-stage venture capital investments in disruptive technology companies, including investments at the pre-seed, seed and Series A rounds. As a Chicago-based investor, more than half of Lightbank’s capital is invested into the Midwest. Since its inception, Lightbank has backed companies including Sprout Social, Tempus, Udemy, tastytrade, Extend, Klover and Paytient at the seed stage.