2022 was a mixed bag for venture capital. Fundraising hit an all-time high as new capital flowed into venture funds at record levels. U.S. venture funds raised $162.6 billion in 2022, which was up from $154.1 billion in 2021 and $93.3 billion in 2020. However, according to data from PitchBook, deal activity for 2022 totaled $238.3 billion, which was down from 2021’s record of $344.7 billion. The decline in VC deal activity in 2022 was likely due to a number of factors including poor market performance of now-public VC-backed companies, supply chain disruptions, the continuing war between Russia and Ukraine, sustained and increasing inflation, increased interest rates and tempered expectations around the financial projections of VC-backed companies. Lastly and perhaps the worst fact, venture capital exit activity in 2022 plummeted to $71.4 billion, a 91% decline from 2021 when exits amounted to $753.2 billion.
While the VC market doesn’t directly impact angel and seed investment philosophies (which is the fundraising stage for most of 05Advisors’ clients), we believe that many of the VC trends outlined below will strongly influence early-stage and angel investing.
As we look to the remainder of 2023, what can founders expect from venture capital? Our thoughts at 05Advisors….
Longer Deal Timelines: VC funds have plenty of dry powder. However, they will take longer to approve an investment as they are doing more due diligence and negotiating harder on terms. Simply put, deals will take longer to get done. Founders looking to raise new capital should plan for a longer runway and have back-up plans for short term capital needs (e.g., convertible debt or SAFEs).
Emphasis on Corporate Governance: Given the frothy valuations and projections in recent years, founders should expect that VCs will look for ways to hold management more accountable. VCs may negotiate for more consent rights and may alter compensation structures to include more performance-based compensation for the management teams.
Down-rounds: With the high valuations in recent years, VCs have started to, and will likely continue to, push for lower valuations. Founders will need to adjust expectations as to ownership levels.
Alternative Capital Sources: As VC funding becomes more difficult and time consuming, founders may look to tap alternative sources of capital. These include debt financing (venture debt and other forms), financing based on accounts receivable, licensing agreements or IP-backed secured loans.
Diversity: The number of VC funds and angel networks purely focused on female or minority led startups have increased significantly. Following the path of large companies, VC funds are increasingly reporting the diversity figures of their portfolio companies. Female and minority founders should actively seek out these sources as a funding option.
Investment Terms: As VCs are currently in a stronger negotiating position, founders should be prepared for more aggressive deal terms such as:
- Accruing dividends
- Enhanced liquidation preferences
- Enhanced anti-dilution mechanisms
- Right to force a sale in shorter timeframes
- Broader scope of consent rights
In December 2022, Forbes published its “12 Predictions for Venture Capital in 2023.” A few of the more interesting quotes and observations from that article included:
“Recessions are a great time to build significant companies (discontinuity leads to opportunity). Generally in a recession the lack of money forces people to be more creative, solve only problems that people are truly willing to pay for (even when budget is tight), and be more frugal, only spending on things that move the needle.” – Mar Hershenson, Managing Partner, Pear VC
“We have no doubt that female founders and female-led funds will prove resilient, and more investors will double down on diversity as the smart play in 2023. Long story short, if you’re not backing women, you’re losing out. Data shows that female-founded companies continue to beat out the broader market by exiting faster, with higher values for investors.” – Erin Harkless Moore, Director of Investments, Pivotal Ventures
“We will see more real companies and better investors. Less money in the system means companies need to have better operational excellence (do more with less money). Investors are also going back to basics. Diligence is back, along with appreciation for companies that are building real value, not relying only on future value. Less founders. Less investors. More opportunities. When it is harder, the tourists leave.” – Mar Hershenson, Managing Partner, Pear VC
The startup world is anything but predicable. Founders need to be prepared for an uncertain fundraising market in 2023 and flexible in their approach to valuations and investment terms. Despite the current environment, we continue to believe that companies with great products/services and a strong management team can build partnerships with venture capital and other investors on terms that favor both parties.
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Mark is a master of M&A and startup financing strategy.