2023: Some Observations On The Year That Was

As we near the close of 2023, we can reflect on the year that was and key learnings from some of the major news events this year and how rapidly rising interest rates have impacted private markets in unexpected ways.

Shaken Confidence Further Shook with Silicon Valley Bank’s Collapse

2023 began with muted deal activity and some shaken confidence, especially with the FTX scandal at the end of 2022 (more on that later) and continued headcount reductions. Then, in March 2023, Silicon Valley Bank (SVB) collapsed due to a duration mismatch and an ensuing bank run. The aggressive rate rises since early 2022 brought this mismatch to the fore, an issue not obvious in a low rate environment. The news reverberated across the industry as startups and funds globally recognized the need to diversify their banking relationships and heightened the focus on risk management. Startups were also concerned about the potential longer term ramifications if SVB did not survive given it was the top venture debt provider in the valley and a strong partner for startups and founders. The widespread panic given the possible contagion across the banking and financial sector more broadly was ultimately short-lived with the Federal Deposit Insurance Corporation (FDIC) guaranteeing deposits. Given the value of SVB and contribution to the technology ecosystem, the sale of its UK arm to HSBC and commercial banking business to First Citizens BancShares was highly welcomed.

Venture Debt Complementary to Equity

With equity private and public markets remaining tight here in Australia, founders and management teams have had to be creative in managing their balance sheet, from cost cutting to looking at alternate sources of capital. Venture debt has continued to emerge as an asset class complementary to traditional equity to help founders optimize their capital structure. Equity is a more expensive form of capital given its dilutive nature. Currently this is amplified by the more compressed valuation multiples in correlation with higher interest rates.

Accordingly, companies can leverage venture debt to lower their average cost of capital. Unlike traditional debt, venture debt has a higher level of risk and generally involves an equity kicker (warrants) to lower the cash costs of the debt while also providing the venture debt provider with aligned upside should the company perform.? However, the right type of funding for any given business should be assessed holistically and case by case based on the needs of the business, debt capacity and cash. Another key learning is that companies should not be looking for venture debt to bridge to the next round or when cash runway is about to run out. Venture debt is best used to access growth initiatives, fund acquisitions and unlock tied up working capital. It is important to work with lenders with the flexibility to work with companies who understand how venture and growth companies do not often have a linear path of execution on their growth strategy.

Stephanie Hamlyn , Senior Investment Associate from Partners for Growth , observes:

2023 has been an interesting year for all investors given the challenging equity conditions coupled with the macro environment of rising inflation and interest rates. The complementariness of debt for growing businesses has become more prevalent this year with an increasing amount of management teams wanting to explore the possibility of incorporating debt into their capital stack. When used correctly, debt is a valuable and flexible source of capital for companies who are reinvesting their profits to fuel top line growth, provided they have proven their product/service has market fit and is generating positive unit economics.

Private Capital Markets – ‘A Tale of Two Cities’ and M&A is Not Such a Bad Idea After All

Australian venture also saw its first major high profile collapse for business models that were in vogue in 2021. With Milkrun’s high profile collapse in April and subsequent resurrection by Woolworths, venture capital funds in Australia moved away from the religion of “growth at all” costs” to sustainable growth. The higher rate environment and both depressed sentiment and confidence has impacted capital raising for very high cash burn businesses with questionable unit economics. Many investors sat on the sidelines to wait for the dust to settle. However, with the short-lived panic raised by SVB and financial stability brought back to the banking system, VCs continued to evaluate deals with a more improved outlook by mid year, albeit with longer diligence timeframes.

While many private capital managers continue to want to compound their returns, there has been a growing shift towards the importance in Distributed Value to the Paid In ratio (DVPI). High profile unicorn names like Canva, Safety Culture and Employment Hero plan to or have completed secondary sales. Over in the US, survival as a unicorn was not assured with three high profile collapses in recent weeks. Veev, Convoy and Olive, collectively raised close to US$2.5bn, have announced plans to shut down. These unicorns are examples where reducing burn too late (or inability to reduce burn) can be the difference between survival and death.

Many companies who raised big rounds in 2021 were able to make their runway stretch and defer raising until 2024. For those companies who dared to raise this year, a tale of two cities became apparent. Many companies with strong metrics and tailwinds have still been able to raise at flat to premium valuations. On the other end of the spectrum, some companies have found capital raising highly challenging, particularly if seeking capital from new investors who were taking much longer with diligence and have become far more discerning. While investors are reticent for a down round in their portfolio, some companies have had no choice.

Further, companies that have limited growth prospects and scale are also finding a second life by merging to accelerate the path to profitability, gain scale or diversify their offering to be the more attractive solution to their customers in a competitive environment.

Kylie Frazer , Co Founder and Managing Partner of Flying Fox Ventures notes:

Startups have historically been pretty reluctant to talk about mergers in the early stages. Part of that is no doubt fuelled by integration difficulties, but bountiful capital markets made it easier to just raise a new round than it was to do the difficult work of a merger. ?In the current valuation environment, there is much more incentive to do that work. ?

IPO Window Opens Briefly and All Eyes on 2024

With the less than stellar aftermarket performance of the much anticipated US venture-backed IPOs of Arm, Klaviyo and Instacart in 3Q of this year, many IPO hopefuls are now waiting until next year. Shein and Reddit are now reported to be targeting a 2024 listing.

According to CB Insights, there are now 257 venture backed companies looking to list in the next 12 to 18 months, indicating the pipeline continues to build. Further as highlighted by The Information, Jane Dunlevie of Goldman Sachs, is of the view there is a backlog of 700 private tech unicorns looking for ways to cash out shares. Australian companies, Canva and Rokt, were present at Goldman Sach’s annual private investor conference in Las Vegas and are upcoming IPO candidates but will likely pursue a US listing.

Closer to home, the likes of Virgin, Molycop, Mondiale VGL, Mason Stevens and Cuscal are some of the larger and more high profile names who may make a play for listing in the coming year. Similar to the US, the average aftermarket performance and global geopolitical events have seen many candidates defer to the next year. However, this hasn’t stopped IPO preparations or enquiries as companies prepare for liquidity and exit optionality.

According to Kate Galpin , Manager, Listings at the ASX ,

Despite the more challenged IPO market this year, the traditional reasons for listing a company still remain: access to capital, price transparency, liquidity, visibility, ability to maintain control, access to global institutional capital and index inclusion. Importantly, secondary capital raisings have held up well in 2023; a key indicator of the health of the equity capital markets. ASX maintains its leading position, ranking first globally by volume of follow-on offerings over the past five consecutive years. The IPO market is traditionally a cyclical one. There continues to be pent up demand on both sides of the equation with investors looking for investment opportunities and companies looking for liquidity. The market conditions need to be conducive for these to come together and we expect that to happen in the latter half of 2024.

Cult of the Founder, Governance and How Not to Handle PR

It would not be a venture / private market update for 2023 if there is no mention of artificial intelligence, or AI. AI mania has been a key theme over much of the year, driving the performance of the Magnificent Seven stocks (Nvidia, Apple, Amazon, Google, Meta, Microsoft, and Tesla), all of which have strong exposure to AI. This in turn has a been major contributor to S&P 500’s YTD gain of c.20% given its c.28% weighting of the index. Silicon Valley’s obsession with crypto and Web 3.0 over 2021 has made way for AI.

In November, we were reminded about the crypto hype when we saw Sam Bankman Fried (SBF) found guilty of fraud and money laundering while co-founder and CEO at crypto trading platform FTX and trading firm Alameda Research. It was another reminder that governance can be a red flag of underlying problems. We were also reminded of this earlier in the year when Elizabeth Holmes began her prison sentence for fraud and conspiracy at Theranos. Theranos' board had many powerful figures, mainly leaders in plitics and government versus healthcare. SBF presided over co-mingling of customer funds and basic lack of internal controls. He raised over $2bn of capital with the company valued at US$32bn at its peak post a Series C round in January 2022. FTX lacked governance, including a board only comprised of SBF, an external lawyer and an ex-FTX executive). Power was also concentrated amongst a small group of executives and there was little to no compliance.

According to John J Ray III, FTX’s CEO post the company filing for bankruptcy in November 2022,

Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here

More recently and dramatically, over 4 days from mid November, we were gripped by the dramatic firing of Sam Altman (CEO of OpenAI) by its board and rapid reinstatement following pressure from investors and 738 out of 770 employees (96%) demanding Sam’s return. OpenAI started the current AI hype and for a short period of time looked like it would self-capitulate. The OpenAI debacle also called into question governance and conflicts between non-profit and for-profit organisations and different objectives from a governance perspective.?

Furthermore, there was also a share sale plan in progress at a valuation of $86bn for employees. Clearly the board missed the memo to not make management changes while in the middle of a transaction.

The board’s statement was also very vague, offering no tangible reason for Sam Altman’s dismissal and raised more questions and intrigue.

“Mr. Altman’s departure follows a deliberative review process by the board, which concluded that he was not consistently candid in his communications with the board, hindering its ability to exercise its responsibilities. The board no longer has confidence in his ability to continue leading OpenAI.”

It was also noted that investors including Microsoft (who had invested US$13bn and had a right to 49% of profits) and other VC investors were also left in the dark up until the announcement. Also, to get an investment into the hottest startup, was there more that could be done in terms of diligence around the governance structure and also a requirement for a board seat, observation or notification rights to pre-empt the ‘key man’ risk?

The 'cult of the founder' (in a more positive sense compared to the Elizabeth Holmes and SBF situation) was clearly that Sam Altman had a loyal employee following, who would all vote with their feet without their leader.

However, was this fierce loyalty to their leader or loyalty to what they saw as a material risk to the value they could crystallise from the share sale plan? It also helped that Microsoft and venture backers were highly supportive and applying pressure publicly. ?Ultimately, there was a board shake up with the departure of Helen Toner, Tasha McCauley and Ilya Sutskever who reportedly had concerns around AGI safety and Altman's various potentially conflicted business interests. The new board will initially comprise: Bret Taylor (Chair), Larry Summers, and Adam D’Angelo (the only original board member to retain his seat).

On communication strategy, Danielle Veivers , Senior Communications and Strategy Consultant, highlights:

“In the case of OpenAI, we witnessed how an issue can rapidly spiral out of control when the communications strategy is not well planned or executed. Governance, transparency, leadership, and consistency of message are vital in a crisis, and we saw the opposite from the OpenAI board with high-level statements and an avoidance of questions from investors, employees, and broader stakeholders. In addition, OpenAI had a key man risk, hanging its brand, reputation, and investability on the persona of CEO, Sam Altman. When it comes to issues management, preparation is key. OpenAI needed a clear succession plan, strong messaging, and a well-developed execution strategy across all stakeholders. In its absence, we have seen the impacts – a loss of control of the corporate narrative, loss of confidence in the board and leadership (outside of Altman), and a serious knock to the reputation of OpenAI moving forward. A timely reminder that communications should be an integral part of all corporate activity.”

Alarmingly some discourse also pointed to the founder being the only person to lead this company – what about ‘Key Man’ risk and risk of unchecked power and oversight? This also leaves us with the question of whether the new board can have the right skills matrix which balances both growth and the risks to humanity posed by AI. This should surely be a focus for the interim board as it looks to build out the board composition. As Microsoft CEO Satya Nadella noted in an interview with Bloomberg he desired some governance changes and that

"Surprises are bad".

With the new interim board, it was recently announced that Microsoft will become a non-voting observer on the non-profit board. While it appears business as usual with the tender offer back on track, Altman back in the top seat and , governance of OpenAI to balance the mission of the non-profit and profit focus of its investors will be closely scrutinised

In Conclusion

What an eventful 2023! As we continue to adjust to a higher rate environment, investors and companies alike can no longer rely on “the next round” being there and will need to be laser focused on managing cash positions, exits, stakeholders and exploring the capital structure toolkit. With the recent high profile newsworthy events, risk management and governance will also be highly top of mind alongside a PR strategy.