Author - Yannick Oswald
Many entrepreneurs, from around Europe, reached out to me over the last weeks, all with one question: 'What is going on in VC right now?'
What is happening in the market?
While 2022 should have just been a transition year to normalcy, the economic crisis now hit the last outposts of the tech world instead. All the big names (besides Apple, whose stock is holding up) see their stocks decline massively (Meta reached 2015 levels two weeks ago), and the private markets funding crunch now entered the earlier stages as well. Only the ‘crème de la crème’ with massive market potential will get valuations somewhat close to what we have seen in the last few years. It feels like the final wake-up call for those who didn’t get the memo yet.
The keyword is 'short-term volatility'. But make no mistake, mid- to long-term, tech will continue to dominate and drive the majority of economic growth.
What is going on in the public markets? Tech is getting back in shape... 2022 and 2023 are transition years.
How did we get here? Riding the wave of cheap cash and accelerated growth driven by Covid, tech companies went on hiring binges and just accumulated too many 'resources' over the last years. Why? Well, to support the accelerated growth ambitions, and just because they could. The lower the rates, the higher the spending power. The party was on.
Headcount growth has been massive over the last years. For example, ‘to get back to 2019 employment levels, Meta would have to lay off almost half the company and Google ~30%.’ With growth back to pre-Covid levels and operating metrics deteriorating substantially with massive spending, the market is skeptical - to say the least. Not surprisingly, tech is down 70% this year. ‘Looking at this chart, it is clear that valuation multiples for public tech were out of line with historical norms.’
Tech is getting back in shape now. The result is layoffs (or slower hiring) across the industry today. Most good tech businesses will be able to do so quickly as much of the accumulated operating cost is driven by human capital. Kyle put it well.
Those with tougher business models, meaning lower gross margins, will struggle more to do so quickly as they would have to cut both, operating costs and COGS. And the latter is a tricky one - as it often relates to the business model itself and the attached (unavoidable) structural costs. One might think of scooter and quick commerce players, but the same accounts for SaaS businesses with lower gross margins. As Bill put it: ‘The more we get into peaky valuations territory, the more optimistic we get about business models that are lower margin...'
So, 2022 and 2023 will be the time when everyone moves from growth at all costs back to growth based on operational excellence and profitability (here an excellent thread by Jared on what this means). Everyone else will be punished. The most prolific recent victim in Europe is probably one of the UK’s tech flagships, Made.Com. After going public last year only at a £775m valuation, the company just appointed administrators as it couldn't raise the capital needed to weather the storm and reach profitability. Global supply chain challenges didn't help, of course.
So, here is my outlook: By Q4 2023 / Q1 2024, public markets will acknowledge again that tech companies are just some of the best businesses out there. Private market funding should follow a year later or so. (Most) tech companies are still performing extremely well, they just need to get their house back in order...
What is happening in private markets, and what is the state of VC funding?
These tech hiring binges were not limited to publicly listed companies. In many cases, small startups, often pre-product market fit but raising vast amounts of capital, frequently hired rapidly ahead of revenue. This happened across growth stages. The result is this: Aggressive spending on growth and massive inflation. Basically, too many unicorns had been minted for public markets to absorb. The unicorn valuation based on a few million in revenue contrasts sharply with normal public market norms - and even more sharply with today’s market.
There is more pain ahead for these overvalued private companies as most won’t raise at such favorable terms in the future. The economy should continue to cool in 2023 with the central banks' anticipated continued rate hikes.
The most significant quarterly decline on a global basis year over year since the mid-2000s.
European venture funding in Q3 2022 continues to fall, sliding to its lowest point in nearly two years. Q3 funding in Europe totaled $16B, down 44% year over year and 35% quarter over quarter. This downward trend in the past quarter is in line with global funding trends.
But, while the decline at the later stages was apparent earlier this year, the biggest dip quarter over quarter was at early-stage funding (down 40%) to below $5B. The late stage still fell by a greater proportion year over year (and with it the number of new unicorns), but early-stage will follow suit. This is normal, as the impact of the public markets takes time to tickle down. Therefore it is not surprising that year over year seed-stage and angel funding fell by a lesser proportion compared to the rest and is ‘only’ down 29% quarter over quarter (largest drop so far though) and 20% year over year.
These are lagging indicators, of course, but it is now clear that European VC firms across stages have scaled back their investment pace. And we are still above 2020 quarterly levels, so we should expect the downward trend to continue further.
What does this mean for tech founders?
Great companies will still get funded, of course. But we are all confused by the current environment: Record levels of dry powder but less financing. Last year all growth, now profitability? Weird deal structures, is this fair? Here are some clarifications.
Closing a round takes longer, and valuations are lower. But they are still happening! Median and average seed and Series A funding rounds have actually held up so far in 2022 compared to 2021 amounts. Median and average funding from Series B onwards declined. My feeling is that Q4 data will show a downward trend. Only the ‘crème de la crème’ will get valuations somewhat close to what we have seen in the last years. While not reflective of our industry, the recent hot startup blow-ups do not help in the short term. Reach out to VCs early, build trust, and convince them that your business is the real deal. This will continue until the end of 2024 as public markets will not recover until end 2023 / early 2024.
It is a great time to hire brilliant talent, especially at the early stage. Nothing is lost, nothing is created. There is so much great talent out there today. And many want to get back into the office to join ambitious startups and company cultures. This might be the best period in a long time to launch a new company and build a great product. You don’t have to raise massive seed rounds anymore (at bloated valuations that put your cap table at risk in the mid-term) to be able to build your fundamentals.
Deal structures are getting more complicated. But that is often to clean up the mess of the last years. I have seen many weird deals with 'loose terms' over the previous years and months (see this post on SAFE nightmares, to give just one example). More complicated deals with creative financial engineering are popping up all over the place to clean up with the tumultuary practices of the past. Experience on your cap table matters now. Many in VC haven't dealt with deals with investor-friendly terms like senior liquidation preferences, warrants, anti-dilution preferences, ownership preferences, pay-to-play, etc.
There is no fair or unfair. But the frustration and exhaustion you might feel right now are common to everyone. This is not specific to your business. There is really no upside in complaining and dragging out the hard decisions. We all signed up for this when we joined the startup world. So let’s get over it, do what has to be done, and get back to building.
Adapt your plan to weather the storm. Every business is different, of course (nice-to-have vs. must-have, cash in the bank or not so much left, high margin vs. low margin, etc.). At the end of the day, it is simple. What targets put you in the best possible position to raise your next round while not being overly reliant on external capital in the next 18 months? As Gil put it: ‘Every sales pipeline is getting re-evaluated, and every sales target is looking a bit too optimistic right now. No one is 'killing it.' This means that your situation is probably better than you think it is - on a relative basis'.
There is more dry powder than ever. Yes, but it is simply being deployed slower. Why? There are two reasons. First, it all goes back to the food chain. The weak performance of public markets and the little M&A activity (the latter should increase in 2023) of the last months weigh heavily on the NAV of the diversified portfolios and the cash management of every asset manager out there. LPs (investors in VC funds) expect GPs to be more cautious. Second, VCs want to show results before asking to withdraw too much additional cash and want to manage their reserves carefully to support their existing portfolio. Results are just coming in slower.
The Outlook: There is no room for long-term pessimism. Don’t let the current narrative become all-consuming.
When we look at the broader picture of innovation capital, this is really just a blip. And, by definition, a blip is short, meaning a few years 😉. We are already a year into this one. There is no room for long-term pessimism in technology. Downturns come and go, but innovation will always represent an outsized proportion of economic growth. Most importantly, tech and internet companies continue their unstoppable growth. In the last 4 years the internet economy grew seven times faster than the total U.S. economy, now accounting for 12% of GDP.
Yes, 2023 will be hard. But there are many reasons to be optimistic. Our portfolio companies continue to raise capital, and can hire better talent. Not only is tech penetration accelerating, but it is very early days. Here some perspective: Cloud computing penetration is only at 10-15% in the most developed economies, and overall digitization across sectors is at around 30-35% only. Think about healthcare, education, space, big data, encryption, online content distribution and compensation, banking, etc.
I would argue that we are very lucky to be alive right now. In the grand scheme of things, global quality of life has dramatically improved in the past decades. In 1820, 94% of the world’s population lived in extreme poverty. Even in 1910, 82% of the world’s population lived in extreme poverty (today less than 10%), while child mortality decreased from around 40% to 4%. Until 1945, less than 10% of the world’s population lived in a democracy (today nearly 60%), while literacy increased from 40% to almost 90%. And innovation played a crucial role in solving these challenges. That is not to say that everything is perfect right now. Social mobility is stagnating, and equality of opportunity has receded in many developed countries. So if I have to take a bet, it will always be on tech...
It is time for founders to be picky again...
That's a good reason to take money from a firm that stands behind its portfolio companies. At Mangrove, we have never failed to do at least one follow-on round when a business is performing well. We don't promise the next round. We don't commit to it. But we are supportive to a fault, and are proud of it. Being an entrepreneur is hard. Having supportive and caring investors helps. In the market we are in, it will help even more.
Last week I visited a cool project in Paris, the NFT factory. It is sponsored by a collective of NFT fans (founders, investors, artists, etc.). While a small venue, it has a cool vibe and the ambition to educate on this new format. The one thing I admire about NFTs is that it has the potential to finally give back creators ownership of their art in the online world. The format will fundamentally change content distribution and monetization models. Exciting stuff. I will spend even more time in the city of lights over the following months. Hit me up if you are around.
Life is awesome,