The Direction of Early Stage Valuations

To avoid disappointment, you need to be able to bridge the gap between expectations and reality. However, at the moment, there appears to be a relatively large gap between the expectations of early-stage founders and the reality of what is being funded. Based on a number of conversations that we have had with founders recently, there has definitely been a shift in sentiment with fewer conversations with investors emerging as the funding environment continues to tighten.

There were a number letters that went out to founders from YC and Sequoia early in 2022 to warn that the funding environment was going to tighten up. While it normally takes a while for these changes to trickle through from the US public markets to the Southeast Asian private markets, it appears that there are few founders that have taken note of what’s happening. We discussed the changes that we were seeing briefly at the end of last year.?

The tightening will likely continue to get worse as there are a number of headwinds that are starting to face the early-stage investment space in Southeast Asia. Firstly, there were a number of new funds that sprung up over the past couple of years which were operated by people who had limited experience in investment or operating early-stage companies. There was definitely a trend towards Venture Capital being perceived as “cool.” Considering the number of blow-ups in the space over the last few months, with FTX blowing up and Sequoia India weighing “special audits” of several investments after having frauds uncovered in almost half a dozen portfolio companies over the last year, the gloss is starting to fade from venture investing. The role encompasses more than just writing cheques and flirting with founders. People are starting to realise how intensive it can be if you want to practice the art well. This means, there are fewer funds entering the arena and subsequently fewer cheques written overall.

Secondly, there have been a number of funds that have been deploying heavily over the last few years. They have been investing into companies with cyclically high valuations. They will now be forced to try to smooth out those high valuations with more reasonable valuations. For example, while some might consider 6-8x revenue as an acceptable mid-cycle multiple for making an investment, if the funds invested at 15x revenue, now they will be looking for investments at 4x revenue to try to get their overall average multiples back into that mid-cycle range. This will feel like a reprehensible position for founders that didn’t benefit from the higher valuations previously. The funds that deployed at higher valuations will be forced to wait for lower multiples, meaning that there will be less capital that’s actively seeking a home.?

Thirdly, some of the funds that had started in the past couple of years are now realising that a majority of their portfolio companies are reliant on external capital and operating in spaces where there are questionable unit economics. This means that the funds need to retain sufficient capital to be able to support their existing portfolio companies with bridge rounds as opposed to backing new companies. The hope being that the existing portfolio companies will be able to reach a sufficient level of scale to become profitable.?Investors were previously able to suspend belief with start-ups because of the FOMO that comes from not being a part of the NEXT BIG THING. However, now, more investors are starting to ask “Whether all trees can grow to the sky?”

This alludes to another reason that funds are investing less today than 12-18 months previously and this could be more specific to the environment in Southeast Asia. There are some investors and specific incubators that believe that all businesses can be venture backable businesses. However, to be able to deliver the kinds of returns that justify for the risk of taking a number of donuts, venture backable businesses need to be able to scale quickly without taking on marginal capital. This is a pertinent problem in Southeast Asia where there are a number of relatively small markets with different cultures, languages, and regulations. What works in one country may not scale to adjacent countries. A lot of the businesses that found venture funding over the last couple of years might struggle to find the scalability that they were looking for. This is a feature and not a bug, there was never meant to be an infinite number of venture backable businesses. There will come a time, when there are more funds with certain sector specialisations but we are very early on that adoption curve presently.

Conclusion

All of this needs to be balanced against the fact that there are still a number of funds that are running up against their deployment period and need to make investments. That means that the faucet won’t completely be turned off but it will seem like it’s sputtering as some funds try to complete their deployment in a more challenging environment. The disappearance of new funds with looser due diligence requirements, funds seeking lower valuations, and questionable unit economics are leading to a more challenging environment overall.

FWIW we’re still deploying at Resolution Ventures as we always have been.