Good news: Our world is flat

While venture capital’s long-term trajectory is an upward curve of innovation and growth, the route is not straight, but a zigzag. We have hit one of the zags.

The current funding environment for startups is challenging.

Publicly-traded tech stocks have fallen and interest rates are rising. Fears of a global recession in the wake of the Covid-19 pandemic have been exacerbated by Russia’s invasion of Ukraine. The world economy faces staggering inflation, uncertainty over food and energy supplies, a long tail of Covid lockdowns in China, and continued supply-chain disruption of semiconductors and other components.

What is the place of high-risk startup investment in such a precarious climate?

It is important to remember that while venture capital’s long-term trajectory is an upward curve of innovation and growth, the route is not straight, but a zigzag. We have hit one of the zags.

After years of explosive growth in which global VC investments increased tenfold, doubling in a single year from 2020 to 2021 to about $650 billion, the curve has flattened in the first quarter of 2022. In Israel, where VC investment jumped by 150% from a then-record $10 billion in 2020 to $25 billion in 2021, startups attracted $5.6 billion in Q1 2022 – indicating an annual rate of approximately $22 billion, slightly below the previous year.

So VC investing this year so far is roughly flat so far compared to the record-breaking amounts raised in 2021 – but in this challenging climate, if the VC world is flat, that is very good news. If we can hold this market level after last year’s surge, it will be a major accomplishment. The notion that every startup is going to raise money in each round at a higher valuation is not a law of physics. Founders and companies need to internalize the effect of the current market on their fundraising.

Occasionally, startups need to take a pause in terms of valuations but must go ahead and raise money. If they are growing fast and burning cash, they have no choice. They need to extend their runway and finance the expansion of their business before they can reach profitability or an exit. Growth is not a constantly ascending elevator. It can be a bumpy staircase, with occasional flat steps and stops at intermediate floors where companies must pause and catch their breath. This is one of those times.

Equity capital is not always the only answer. Growth-stage startups with early revenue and a clear pipeline should consider adding alternative funding strategies like venture debt to their financial toolbox. This can provide another source of cash on top of equity rounds without diluting existing investors and founders.

Sometimes, a company might even decide on a down round. That may be disappointing to current shareholders who have become accustomed to ever-rising valuations, but a down round is better than no round and can provide the financial fuel a company needs to reach its next milestone.

One of our CEOs felt insulted recently when a Tier-1 VC said it wanted to renegotiate a term sheet in light of current market conditions. The CEO told them to get lost and went looking for a new lead for his investment round on the previous terms. Three months later, he is still looking.

Founders must realize that market conditions have changed and so have investors’ expectations. As noted by Jason Goepfert, Chief Research Officer at Sundial Capital Research, more than 45 percent of Nasdaq stocks are now trading 50 percent below their 52-week highs – and more than 22 percent of the members of the Nasdaq index are down 75 percent. “This is the first time we've ever seen this kind of damage while the indexes were (relatively) close to their highs,” Goepfert explains. “Since it’s more of a dragged-out affair as opposed to a quick crash like 2020, it seems more likely that we're in a slow-rolling event that will drag on the indices.”

Private companies cannot remain unaffected when valuations and sentiment in the public market are sinking into such negative territory.

The private market tends to lag the public markets by a quarter or two but, sooner or later, if Nasdaq continues on its current trajectory, private tech company valuations will have to suffer a similar haircut. Startups need to accept the situation and prepare for a tough period ahead.

But investors need not despair. Venture investing is not about short-term valuation or even the valuation today, but the valuation at exit. Many of these companies have tremendous growth ahead of them. Their first priority is to secure the money they need in order to grow. While it is preferable to secure funds on the best terms possible, the most important thing is to ensure that they have the cash runway they require. Being realistic is essential. Valuation is often closely tied to a company’s performance, but the market conditions may require a rethink. Even if a company is performing spectacularly, in a down market where comparable firms are trading down, valuation expectations must be adjusted accordingly.

If the amounts of money being raised continue to hold at or near the record levels we reached in 2021, a flat round this year should not come as a disappointment. It should be seen as a sign of maturity and something that may even be a cause for celebration in today’s tough market.

About ‘Investors on the Frontlines’

I’m the CEO and Founder of OurCrowd, the global equity investment platform that gives individual accredited investors access to pre-IPO startup deals alongside top-tier VCs. If you are an investor, private family office or financial advisor, subscribe here for my biweekly commentary or follow me on Twitter. I welcome your comments in the response section below.