The author is an Associate at the Silicon Valley Venture Capital Fund and Venture Scout at the University of California, Berkeley SkyDeck Accelerator
What is really the impact of the market situation on the early-stage startups that need to raise capital? How is investment practice changing? There are a number of effects of the crisis on investors that every entrepreneur must understand when it comes to raising capital.
First, the rate of investment of venture capital funds is changing. Funds are moving to a defensive strategy, meaning their thinking is primarily directed at supporting existing portfolio companies. In the context of new investments, many funds adopt a Hold strategy, which means that until the market stabilizes they choose not to invest, or to invest little since the markets are unstable. If we look at the financial crisis in 2008, the amount of investments in startups in A, B and C rounds fell between 40-47% in 2009 and returned to its original level only 3 years later in 2011. This means that while the Dry Powder is high but its availability is low. Beyond the pace, there is also a significant change in the investment criteria. The startup journey is basically a risk management journey. First “product risk”, can we develop a solution that works? Then “market risk” which talks about Product Market Fit and so on. Liquidity risk, the risk that the money in the company’s cash register will run out, is a risk that accompanies all stages of the startup’s life, but in a period of crisis, this risk increases significantly. Each fund has a weight matrix according to which it makes investment decisions:
Liquidity indices (the financial capabilities of existing investors), growth indices and general indices (market size, team quality, degree of market competitiveness). In the market, the growth indices and the general indices occupy the majority of the percentage of the investment decision, since investors are optimistic and think that a company with a suitable market that shows signs of growth and adaptation to the market (Product Market Fit) will continue to grow and raise capital easily. In the bear market, the main concern is that the cash tap will be shut down and therefore investors put most of their investment weight on the basis of liquidity indices.
Liquidity risk
That is, investors will dwell on questions such as: Do the existing investors in the company and / or the investors who have committed to participate in the current round have the financial capabilities to continue to support the company to reach its goals in the bear market as well? Have the existing investors in the company chosen to continue investing in the current round? For if they do not invest now, they are unlikely to invest in subsequent rounds, which increases the risk of liquidity.
Of course, the immediate effect is a decrease in the value of startups, a value determined by venture capital funds. The change in value is due to the multipliers in the public market, profit multipliers, revenues, etc. The main discussion is how sharp the decline should be, 2013-2021 data show that the “corrections” of the public market affect the late recruitment rounds, the D rounds (but with a weaker intensity than the public correction) while in the A rounds almost no impact is measured. These figures are not correct in a recession, or in a long-term bear market, but only in temporary corrections. So my recommendation – play between the two approaches, as it is not clear whether we are in a recession or a temporary “correction”. Beyond value, the bear market means fewer mergers and acquisitions and therefore the fund’s exit / liquidation strategy (which has a lifespan of 8-10 years) is changing. Funds will further examine the unit’s economy, the CAC: LTV ratio and the economic model. An unhealthy single economy will require explanations, even if customer growth shows a J-curve.
Non-core industries
In 2021 many funds have invested in industries that are not their core area, the explanation for this is that during growth periods funds tend to examine investments even if they are outside their area of expertise, invest your time in funds dedicated to your field and do not waste time investing in your industry. Their core domain. In general, in times of crisis funds tend to save costs, reduce manpower and invest a lot of time in their portfolio companies. Pay attention to which investors you want by your side and who you are turning to and how, so that you do not find yourself being allocated time only from new funds (and in Israel there are many) with few existing portfolio companies and a lot of free time. Try to raise funds that have available capital, that have the financial capacity to continue to support their startups. Do not be afraid to ask funds: what is the Deployment percentage, how much of it is allocated to follow-up rounds and what is the fund’s historical participation data in the follow – up rounds of its portfolio companies.
Remember, 75% of Fortune 500 companies were founded in a time of crisis. Although the recruitment challenge is much greater, its success is possible and provides proof of significant feasibility.