Where Has All The Money Gone?
Where Has All The Money Gone?
Why there's a funding freeze at the Series B stage and the implications for the startup ecosystem as a whole
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Traditionally, the first stage of institutional capital raised by a startup was called a Seed round. For many founders, this was also the first time they raised capital for their startup. Other founders might raise an Angel round or a Friends and Family round. However, in the late stages of the last economic cycle, this dynamic changed where founders were being given larger sums of capital earlier in their journey.
To give this a name, the Pre-Seed round was invented. Previous Seed round definitions were brought forward and applied loosely at the Pre-Seed round and companies with no product, no revenue and barely an idea were given hope and capital from VCs who wanted to get in at a low price and generate large returns for their investors.
At the time, this was a fairly popular move within the startup ecosystem. Talented founders were able to comfortably leave high-paying roles and pursue large opportunities. VCs were seen as founder friendly if they wrote large sums of money, without strenuous terms and at high valuations.
In 2021, this got out of hand, as the total global venture capital deal volume stood at $677.9B. Over the last year and a half, this amount has come down substantially, in 2022 it totalled $432B and as of Q1 2023, $75.7B was invested in startups across all stages.
From the chart above, the biggest thing to note is the decrease in the amount of later-stage technology funding and that’s what we’ll be talking about in this week’s article. I break down the VC Capital Stack, the multiple compression and why Series B+ funding has come to a stop.
The VC Capital Stack
Venture capital works in stages. It starts at the Angel/Family and Friends Round and moves through Seed to Series A, B and C+ all the way up to Pre-IPO. At each stage, there is a healthy ecosystem of funds that solely target that stage or a few of the stages on either side. E.g., A VC fund could be focused on Pre-Seed, Seed and Series A rounds, or solely on Seed rounds. The size of the fund usually dictates which stage it targets. As the raises are smaller at the Pre-Seed and Seed stages, smaller funds usually play here. Larger funds might spread themselves from Seed onwards or solely focus on Series B+ rounds.
As such, each part of the ecosystem relies on each other. Later-stage funds rely on early-stage funds to pick good companies and to make sure these businesses have strong fundamentals. Early-stage funds rely on later-stage funds to fund their investments and to encourage fast growth. By doing so, operators at later-stage companies get to see what good looks like, earn money through ESOP and become motivated to build their own businesses.
In 2021, this cycle hit escape velocity. Companies were being marked up faster than ever, operators became paper rich and were even more incentivised to start their own business as capital became cheap to source. The competitiveness of the VC market fundamentally shifted the market dynamics of the asset class.
Large funds were able to raise even larger funds creating both pressures to deploy lots of money, but also an incentive to raise new funds quickly to stack their management fees. This meant that typical Series B+ funds started to deploy capital in earlier rounds to buy optionality and access to later rounds of hyped startups. Tiger Global is by far the best example of a fund that pioneered this movement. They participated in 116 early-stage venture deals globally in 2021—more than the prior eight years combined.
As such, deploying more capital, led to high valuations at high revenue multiples, with the belief that later-round investors had the appetite to invest at an even higher valuation. Obviously, this vicious cycle created a bubble that is now in the process of deflating. Equity markets have effectively collapsed and the IPO market is closed. Public market revenue multiples have also compressed further than what was thought to be possible.
This also meant that tourist investors such as hedge funds and crossover investors as well as later-stage funds were not able to meet their liquidity targets by listing companies or selling their stakes before the market tanked. So much so that last week it was reported that Tiger failed to drum up any interest for secondary sales of its portfolio companies.
If the decrease in funding continues, there is a chance that it could cause a break in the flywheel. At the early stage, VC funds look to growth-stage employees as future founders. If there is a lack of belief in the VC model, there’s a chance that these future founders don’t entertain going on the VC pathway at all, and either remain core contributors at growth-stage firms or bootstrap their own businesses.
Whilst I don’t think this sentiment has been observed yet, it is largely reliant on the actions of later-stage VCs. If VCs don’t fund good later-stage companies, these employees won’t have valuable ESOPs and as such not have a healthy cushion to fall back on.
Moving Goalposts
With the decrease in public market multiples, investors who were happy to give out 20, 30 or even 100x revenue multiples, are now reluctant to value startups at over a 10x revenue multiple. Moreover, the thresholds and benchmarks for what a good business looks like at each stage have also moved up substantially. As an example, pre-2021, a Series A investment round might occur once a startup hit $3M ARR. In 2021, this threshold was brought forward to $1M ARR due to the competitiveness of the VC market and now in 2023, this is likely back to $3M. This can be applied to other metrics as well.
This severe whiplash of benchmarks means that startups that raised a Seed round in 2021 targeted a benchmark that is no longer true, meaning they made strategic decisions and burnt capital in pursuit of a goalpost that has now moved further out. These companies hired fast, and burnt through their capital to hit goals and get to the next funding round, yet find themselves well short of unlocking further funding meaning they need to heavily preserve runway.
This shift in mentality towards making layoffs and debating the path forward towards further growth or reaching profitability is one that significantly affects a company's core DNA, morale and the future trajectory for the business. Strong companies might be completely knocked off the venture pathway which demands strong month-on-month growth, and metrics that are always going up and to the right.
The Implications for Founders
The pressure on founders to survive has never been harder. Runway is short, and the necessity to generate revenue is high. There are three things that founders need to be thinking of over this period.
When to be defensive and when to go on the offensive:
We've written about how lots of companies are basically walking zombies, yet from the outside, they still look like shiny objects that raised $5M in 2021. Smart founders should continually be monitoring their direct and adjacent competition to figure out who is still shipping product. By doing so, founders will be able to either pivot or explore new areas that they previously didn't touch due to excessive competition.
Proactive hiring to increase operating leverage:
With so many layoffs occurring, the talent pipeline is filled with operators from a diverse range of organisations. From small startups to large corporates, if founders have been smart about preserving runway early, they now have first dibs on who to hire.
Rather than hiring someone from Meta or Google, look to hire people who have worked at companies in similar markets or products and those who have worked in a variety of different-sized startups. They'll be familiar with market shifts and the trials and tribulations that come with working in an early-stage startup.
Creative revenue generation and cost control:
Some founders might be staring down the barrel, with no future fundraising plans in sight. At this point, you’ll need to be prepared to do anything and everything to save your company.
I recently came across this tweet:
Whilst, this wouldn’t be my go-to piece of advice for founders, for some this might be the only way to keep their company alive. I’ve seen a few businesses survive through 2020 with company-wide side hustles that generated large amounts of cash flow and recurring revenue to help subsidise the main operations of the business. Yes, this is a distraction to the core mission of the company, but when you’re on the verge of insolvency, then you need to be prepared to do anything to stay alive.
Looking to the future
Founders should brace themselves for low-valuation offers. Whilst this might sound self-serving as a VC, it is a reality for many businesses. Obviously, as a founder, you should absolutely try to negotiate up, but be prepared to not have that much wiggle room.
On whether the funding market will reopen soon, there will be a point in time when Series B+ investors will again face deployment pressures and open the chequebook up again. I expect the capital to flow as follows:
High-flying startups that were able to extend their runway, and have comfortably surpassed Series B benchmarks will attract capital first.
Once this wave is funded, investors might take a more thematic approach towards funding startups at this stage that haven’t fully hit the benchmarks required.
Companies that don’t fit an ‘investible’ theme, or haven’t hit their metrics, might be kept alive by their existing investors, but I suspect many of them will unfortunately perish.
Another scenario I've toyed with is that later-stage investors return to dipping into Seed and Series A rounds, but with an option buying strategy. Rather than putting down large offers, a call option buying strategy means that they might deploy a considerably smaller cheque in the realm of $500k - $1M. With this, they can get information rights and then look to pre-empt the next funding round in a big way based on how the company is performing. These funds have LPs that will want them to be deploying capital, and so this is a decent strategy to look like they are doing work and that they're actively hunting for new deals.
In any case, I expect Series B+ funding rounds to still be stagnant through to the end of the year, and only really active for existing portfolio companies. Despite this, there is still plenty of capital to be deployed, and with fewer Seed to Series B rounds being done, those who are able to garner the attention of later-stage investors will be able to take advantage in a big way.
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Abhi