James Murphy is general partner at Forum companies.
2021 has been a whirlwind year for venture capital, characterized by seemingly endless capital, rapid markups and unprecedented valuation multiples. Fast forward to today, and the VC market has undergone a massive reset, changing the game for early-stage founders and investors alike. While some of the changes are obvious, there are also subtler shifts affecting VC firms that founders must navigate in this transformed landscape.
The high stakes game of peak ratings
The consequences of investing during peak valuations can be serious for venture capital funds, as they require significantly higher returns on future investments to offset the high valuations of existing portfolios. Investment returns are significantly tested when more than 50% of a fund is deployed in pre-income startups at high valuations, and later stage multiples are then reset 75%+ lower. It doesn’t take an expert to realize that this is a recipe for underperformance, and funds have some serious catching up to do. Investing is a “What have you done for me lately?” game, and most VCs struggle to raise follow-up funds on the back of an underperforming vintage.
As a founder, beware of potential tensions and misaligned incentives, as VCs flout caution and push founders toward risky, high-reward strategies even when the odds of success are not favourable. I find this dynamic has always existed in venture, but in the case of VCs that need to atone for the past sins of portfolio construction, expect even more.
The changing tides of VC support
When a VC invests in a startup, they commit to providing founders with two things: money and support. The natural default is to focus their time and energy on the best performing companies. In bear markets, I’ve seen things get tougher for founders, and it’s sadly all too common for VCs to deliver on their commitments and abandon underperforming companies in their portfolios. Startups with a proven product-market fit and strong growth metrics will receive full attention, while others still struggling with customer churn or trying to turn around may be relegated to the sidelines.
How do founders avoid this fate? It is important to choose your VC wisely. Backchannel to other founders who have worked with the partner. Find out how they behaved when the going got tough. It is also important to understand the partner’s status within their own company. If they leave the fund, don’t expect the same level of commitment from the remaining partners.
Not all funds are created equal and the current economic climate poses an existential risk to many venture capital funds. Up to 50% of the funds in the start-up phase are confronted with the possibility of closure within the next 12-18 months. There is a very real possibility that the fund you pitch your SaaS startup to will no longer be an active VC by the time you raise your Series A round. Don’t be afraid to study the past performance of venture capital funds as a measure of the likelihood that they will still be active in a few years.
The rise of insider rounds
Insider rounds are on the rise as VCs choose to support high-performing teams within their existing portfolios rather than investing in new ventures. The bar for follow-up capital is extremely high. Expect existing investors to have less appetite for bridging capital to founding teams with medium growth metrics, and for the foreseeable future these companies will find it extremely challenging to raise capital from new investors. Founders should have a good idea of what metrics they need to achieve in order to do an insider round with existing investors and be keen to achieve them.
The end of the “founder-friendly” era
With such easy access to capital in recent years, founder-friendly deals at peak valuations with minimal scrutiny and governance have been the norm, but I’m increasingly noticing investors writing less favorable term sheets. As a founder, be prepared to negotiate pro rata rights, budgetary governance, board construction, and liquidation preferences with potential investors. This is especially true when startups are running out of money and need an investor to capitalize the business to stay alive. Founders need to understand cash burn and proactively raise capital well before the money runs out to maintain optionality and leverage in negotiations with potential investors.
The remorse of the LP’s buyer
As the startup bubble deflates, it seems many limited partners (LPs) are buyer remorse for their venture capital allocations, resulting in a challenging fundraising environment for many VCs. The influx of non-traditional VC allocators during the peak has exacerbated this sentiment, and even advanced LPs struggle with overexposure to venture capital compared to other asset classes. It is precisely at this time that many venture capital funds are trying to figure out how to raise their next fund.
This challenging environment will extend fundraising timelines and force VCs to be more careful with capital, with those who failed to secure capital in early 2022 facing the grim prospect of being unable to raise funds beyond that. At its peak, funds were deployed over a 12-month period, but venture capital funds are now deploying capital more prudently over periods of two to three years.
Early-stage founders should brace themselves for fewer deals and a noisier meeting landscape. In my company’s portfolio, the number of meetings it takes to close a seed round has doubled in recent months, sometimes by triple digits. Many VCs are running out of investable capital or are working through a two to three year implementation window. Founders should be direct with VCs regarding their implementation status and recent investment activity to gauge their genuine interest and avoid unnecessary time and effort.
Embrace the challenge and adapt to change
The great VC reset has ushered in a new era for founders and investors marked by tighter deal terms, selective support and heightened uncertainty. While challenging, this environment also offers a unique opportunity to build stronger, more resilient startups. Remember, there are still VCs out there who understand the unique needs of startups and have the resources to invest in them. Focus on finding the right investors who are as committed to your success as you are, and don’t be afraid to ask the tough questions.