Why the Venture Capital Market Remains Super Exciting – 3 supportive indicators

In mid-May I had the opportunity to join the annual meeting of our venture capital partner TrueBridge Capital Partners in New York. The founders of TrueBridge have been pioneering venture investors, backing some of the most prominent venture managers globally since the mid-90’s. Their industry intelligence is extensive – in fact, Forbes Magazine uses TrueBridge data for its annual “who’s who in the VC-world” rankings such as the Midas List and The Next Billion-Dollar Startups.

No doubt, the foundations of the venture capital market have been rocked perhaps harder than any other asset class during the last 12 months. The debacle around failed crypto exchange FTX, the bankruptcies of Silicon Valley Bank and First Republic Bank, falling valuations across early- / late-stage financings, the closed IPO window, and a deteriorating fundraising environment have dominated the headlines recently.

So is the venture capital opportunity dead and long gone? We do not believe that this is the case, as supported by three key indicators.

1. The shift from growth to profitability creates a talent access opportunity.

Pre-2022, the VC world saw an influx of non-traditional, “tourist VCs” that flooded the market with cash seeking the next “Decacorn.”[1] The oversupply of capital resulted in low-quality companies getting funding and pushing valuations of all companies to unsustainable levels. There was limited time for investors to perform due diligence, terms and conditions were (very) founder-friendly and there was a long queue of investors willing to jump the queue if you insisted on doing proper analysis.

When the macro-economic situation and stock markets turned in the summer of 2022, the fundraising market changed. Since then, non-traditional investors have retreated and market conditions have normalised. Big listed tech companies that had been investing in growth at all costs had to refocus on profitability to regain stock market confidence through cost-cutting efforts, resulting in massive layoffs. For the start-up world, this creates a tremendous opportunity. The pool of A-class developers and engineers available in the job market is great and established VC firms have already begun to take advantage of this opportunity. There will likely be good M&A opportunities for proven, well-funded companies to acquire competitors and their technologies as they run out of cash.

2. Valuations ebb and flow – we’re seeing a return to a normal market.

What goes up, must come down. The interest in venture capital increased substantially during the last ten years driven by global success stories such as Doordash, Snowflake, Coinbase and Nordic / European  equivalents like Klarna, Spotify and Wolt going public / being acquired. Media attention on founders further drove the interest for an asset class that very few previously knew about but suddenly everyone was talking about. Buyout platforms, looking to get a slice of the growing LP pie, set up dedicated growth funds to capture the late-stage opportunity. VC firms expanded their stage focus strategies horizontally as well.

Twelve months into the “positive inflationary” era, funding is now scarce. Companies are being told by their backers to extend their cash runway and avoid fundraising as the risk appetite of investors is historically low. This has created a more sound supply / demand balance and more reasonable valuations. For example, median software valuations are now back to their historical norms [2] at 7-7.5x ARR [3], down from the 25x ARR in 2021. This correction in the valuation of new financing rounds [4] has been the biggest for late-stage companies, where median pre-money valuations have fallen 40% off the peak in 2021 to some 200 musd. Early-stage valuations have seen more modest corrections with median pre-money valuations down some 5-10% at 130 musd, whereas median seed pre-money valuations have held up quite well with median valuations slightly increasing to 18 musd.

Today´s companies scale faster than ever thanks to the pace of innovation and increasing digital adaptation. The amount of time for companies to “grow into” their valuations will likely be shorter. This, combined with the reset in valuations of new investments, tells us that the return expectation for future VC investments is attractive.

3. The VC market is cyclical and impossible to time.

An investor once told me that “the market timing Hall of Fame is pretty empty.” For the venture capital asset class, that holds particularly true. People with long memories recall that the burst of the “dot-com” bubble around the millennia and the great financial crisis in 2008-09 sent shock waves through the entire VC industry. Funding dried up completely with subsequent high mortality rates among start-ups. What many don´t realise is that the lack of capital spurs innovation - and that some of the most high-profile tech companies of today were actually created during those “dark years.” Many service companies that are used in our daily lives, like Airbnb, Stripe and Dropbox, were all created during 2007-2009.

Venture capitalists are opportunistic dreamers by default. What is unique about them is their perspective. Inflation, interest rates, and supply-chain problems are of course also affecting today´s start-up companies. However, venture capital is not about investing in today´s market. It is the capability to spot trends, “see around the corner” and invest in what will be relevant services, concepts and products 5, 10 or even 15 years from now.

Thus, the best way to optimise returns in the VC market is to make sure you remain invested at all times with the best venture capital managers, as you cannot get in / out when the “time is right.” If you want to catch the next wave of success stories you’d better remain committed to the asset class as it is very hard to predict when the market will be “turned on” again. Although the next few quarters may remain challenging for the start-up industry as a whole, innovation never stops and the foundation of future star companies and tomorrow´s returns are being laid now. What has happened during the last 12 months, may in fact have created the best environment for venture capital investments witnessed during the last decade.

Staffan Jåfs is the head of private equity at eQ Asset Management