James Murphy is General Partner at Forum Ventures.
2021 was a whirlwind year for Venture Capital, marked 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 both early-stage founders and investors. While some changes are obvious, there are also subtler shifts impacting VC firms that founders must navigate in this transformed landscape.
The High-Stakes Game Of Peak Valuations
The consequences of investing during peak valuations can be severe for VCs, as they require significantly higher returns from future investments to compensate for the inflated valuations of existing portfolios. Investment returns are significantly challenged when over 50% of a fund is deployed into pre-revenue startups at inflated valuations, and later-stage multiples subsequently reset 75%+ lower. It doesn’t take an expert to realize this is a recipe for underperformance, and funds have some serious catchup to do. Investing is a “What have you done for me lately?” game, and most VCs struggle to raise subsequent funds on the back of an underperforming vintage.
As a founder, beware of potential tension and misaligned incentives as VCs throw caution to the wind and push founders toward high-risk, high-reward strategies, even when the odds of success are not favorable. I find that this dynamic has always existed in venture, but in the case of VCs needing to make up for past sins of portfolio construction, expect even more.
The Changing Tides Of VC Support
When a VC invests in a startup, they are committing to providing two things to founders, money and support. The natural default is to focus their time and energy on top-performing companies. In bear markets, I’ve seen how everything gets harder for founders, and it’s unfortunately all too common for VCs to renege on their commitments and abandon underperforming companies in their portfolios. Startups with proven product-market fit and strong growth metrics will receive full attention, while others still grappling with customer churn or seeking to pivot might be relegated to the sidelines.
How do founders avoid this fate? It is important to choose your VC wisely. Backchannel to other founders who’ve worked with the partner. Find out how they behaved when things got challenging. It’s also important to understand the partner’s standing within their own firm. 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 VCs Funds. Up to 50% of seed-stage funds face the possibility of closure within the next 12-18 months. There is a very real possibility that the fund you are pitching your SaaS startup to will no longer be an active VC by the time you are raising your Series A round. Don’t be afraid to diligence past performance of VC funds as a proxy for the likelihood that they will still be in business in a few years.
The Rise Of Insider Rounds
Insider rounds are surging as VCs choose to back high-performing teams within their existing portfolios rather than invest in new ventures. The bar for follow-on capital is extremely high. Expect existing investors to have less appetite for bridging capital to founding teams with average 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 sense of what metrics they need to achieve to do an insider round with existing investors and be laser-focused on achieving them.
The End Of The “Founder-Friendly” Era
With such easy access to capital over the last few years, founder-friendly deals at peak valuations with minimal control and governance were the norm, but I’m increasingly noticing that investors are 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 particularly the case when startups are running out of money and need an investor to capitalize the business to stay alive. Founders need to have a solid understanding of cash burn and proactively raise capital well before cash runs out to maintain optionality and leverage in negotiations with potential investors.
The LPs’ Buyer’s Remorse
As the startup bubble deflates, it seems that many limited partners (LPs) are experiencing buyer’s 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 sophisticated LPs are grappling with overexposure to venture capital relative to other asset classes. It is at this precise moment that many VCs are trying to figure out how they will raise their next fund.
This challenging environment will extend fundraising timelines and force VCs to deploy capital more cautiously, with those who failed to secure capital by early 2022 facing the grim prospect of being unable to raise subsequent funds. At the peak, funds were deployed over a twelve-month period, but VCs are now deploying capital more cautiously over two- to three-year periods.
Early-stage founders should brace themselves for fewer deals and a noisier meeting landscape. Across my company’s portfolio, the number of meetings required to close a seed round has doubled in recent months, sometimes even reaching triple digits. Many VCs are either almost out of investable capital or are working through a two-three-year deployment window. Founders must be direct with VCs regarding their deployment status and recent investment activity to gauge their genuine interest and avoid unnecessary time and effort.
Embracing The Challenge And Adapting to Change
The great VC reset has created a new era for founders and investors, marked by more stringent deal terms, selective support, and heightened uncertainty. While challenging, this environment also presents a unique opportunity to build stronger, more resilient startups. Remember, there are still VCs 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.
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