By Krista Morgan, GP of Stage, a majority female-led private equity group that acquires controlling interest in early-stage companies
2022 has seen a marked decline in venture funding down 23% in Q2, the largest quarterly percentage drop in funding in nearly a decade. This signals a cooling off in the venture market, however the overall dollars going into venture are still almost double what they were in 2019. Perhaps more importantly, there is also an estimated $290 billion dollars of undeployed venture capital. That’s almost double the annual average amount from 2016 – 2020.
This suggests the floodgates will open and venture funds will start to deploy. The question is what will be different. Unlike the last ten years, capital is no longer cheap. Rising interest rates caused by inflation have created a significant correction in the public markets, especially for technology stocks. Global recession fears also abound which will cause further investment hesitation.
This combination of market forces will force all technology investors, from early stage to growth stage, to rethink valuations and expect greater capital efficiency from their private investments.
Investing in startups is all about valuations. Everyone is looking for the next unicorn, disrupter, to whoever is “building a better mousetrap,” and many investors are on the hunt to find these companies at their earliest stages. The later they invest, the more an investor ends up paying for less of the company.
The likely outcome is that this market correction combined with a huge amount of dry powder is going to reduce valuations, not the amount of capital deployed. In an inflationary environment, investors need to deploy capital, sitting on the sidelines is not sustainable. Investors will seek appropriate value for the risk of the market uncertainty.
Competition for deals has given founders the ability to negotiate very favorable terms. High valuations, super voting stock, and minimal protections for investors. There is going to be a new normal as VCs get back into market with the need to deliver on LP return expectations in a more uncertain environment.
Investors can and will be asking for deal terms that mitigate their risk by protecting downside and securing minimum upside returns. Lower valuations are inevitable, but there are other deal terms that improve investor return and/or give them more control to influence the direction of a company and hold founders accountable to results.
Liquidation Preference
A 1x non-participating liquidation preference has been standard. As VCs seek to maximize returns on potentially lower exit multiples, they may ask for a 2-4x preference multiple or even a participating preference to provide greater ROI on a sale.
Investment Tranches
It has been standard to provide all capital for a new round up front, but VCs can put in levers to prevent more investment if milestones are not being hit. Delaying capital deployment also improves IRR for the investor. This also gives the investor more control over ensuring the founder is providing information and keeping them informed as they seek to ensure the next tranche of capital is coming.
Debt & Equity Structures
Providing debt to a company provides a lot of control and leverage, also more downside protection. SAFE notes have risen in popularity over convertible notes due to their extremely flexible and simple structure. But they provide minimal investor protection, we could see a return to convertible or even secured notes, in combination with standard equity, which will give the investor the ability to have more rights than they would get with straight equity.
Investor Rights
Investors will want to have more rights built into preferred equity agreements and are likely to enforce them more diligently. Founders can expect to have more scrutiny as they comply with information rights and must keep investors aligned to get approval for significant actions. The days of super voting shares that can override preferred investors are over.
Founders and VCs are in a symbiotic relationship that drive innovation and deliver strong returns to both public and private markets. Arguably, the balance of power shifted too strongly to the founder side as evidenced by the public market correction in technology stocks. This combination of a record amount of VC dry powder, inflation, and a possible recession has not been seen before and will inevitably change the landscape of early-stage technology investment.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.