The Venture Capital Cycle
Estimated reading time: 7 minutes
In mid-2022, the venture capital market began to show signs of weakness after years of widely available capital and higher valuations. Weakness continued into the fourth quarter of 2022, with fundraising of $20.6 billion reflecting a 65% year-over-year decline.
From geopolitical conflict and high inflation to declines in public markets, the threats of downward market pressure and rising interest rates weigh on private markets. With an eye on past market patterns, we can anticipate some of the issues investors may expect in the coming year.
When Times Are Good…
In many cases, what is good for the public markets benefits the private markets.
Robust public market valuations generally correlate to higher valuations in private assets over time (i.e., more up-rounds). Also, when public markets are liquid and IPO windows are open, the dollars flow into venture capital, especially later-stage VC, where exit liquidity is robust. Higher values in the public markets also require capital allocators to rotate additional capital to private funds/strategies to maintain targeted allocations. Strategic buyers may focus on private markets in search of better values relative to the public markets, with the added advantage of leveraging their attractively valued public shares and stronger financial positions to complete transactions.
Strong public markets also offer the private markets enhanced access to capital. Exit opportunities tend to be both nearer in timing and higher in value, offering investors the potential to realize attractive returns as companies complete IPOs. Successful IPOs and M&A exits, in turn, leave LPs with investable cash and a need to maintain their private market allocations, enabling successful managers to raise capital and launch successor funds at a faster pace.
Venture round structuring in a strong market generally benefits founders and existing investors more. Competition in the market is high, giving rise to higher valuations as firms compete for attractive investments to deploy capital. Companies are likely to raise capital on more favorable terms, as investors place less value on protective features and are more aligned with expectations for an IPO or fully-diluted outcome in which all shares benefit similarly. In such environments, the standard 1.0x LP leads to a capital stack that reflects seniority by issuance date with less dilution to earlier investors.
Finally, VC debt is more easily secured when there is an active IPO and M&A environment, offering a non-dilutive alternative to equity when bridging to an exit. Longer interest-only periods, longer maturities, and less warrant dilution benefit borrowers.
Favorable terms and the ability to retain control facilitate alignment between early investors, new investors, and management teams to focus on the business objectives necessary to reach an IPO or sale to a strategic buyer.
Competition in the market is high, giving rise to higher valuations as firms compete for attractive investments to deploy capital.
The Other Side – When Times Are Not As Good
When markets turn, many of the aforementioned positive factors reverse.
Weaker public markets increase the timeline and uncertainty of achieving exit values from targeted IPOs or M&A sales, which requires investors to reduce valuations to achieve targeted returns. Acquirers and investors that previously targeted private market opportunities refocus their interest on opportunities in the public markets at lower and more advantageous valuations.
This is compounded by the “denominator effect,” a shift by capital allocators away from private markets to offset declines in public market values.
Listed companies in sectors that tend to attract VC interest were hit especially hard in 2022, making the public market alternatives relatively more appealing.
On the M&A side, strategic acquirers with large cash holdings can afford to be more disciplined in pricing, as there is less competition for deals in the private markets. Increased diligence and favorable deal structuring put power back in the hands of the buyer, allowing them to offload some of the risk associated with an acquisition through more favorable terms or contingent payment structures.
At the fund level, portfolio triage becomes more of a concern as managers are forced to decide which portfolio companies to support and which may no longer justify additional capital and attention. Fewer exits and capital raises exacerbate the issue. Portfolio companies must work to slow cash burn, often by trading off higher growth expectations for reduced cash burn and a longer cash runway. This can be a painful tradeoff for companies counting on a high-growth story to attract the attention of the public markets and strategic buyers.
A liquidity event expected 12 to 18 months from the last round may become increasingly dependent on achieving company-specific milestones and a turnaround in the public markets. Companies refocus to aggressively manage costs to slow cash burn and extend the runway to the subsequent financing round or exit or avoid raising money altogether at lower valuations.
This environment also creates new opportunities for VC lenders to target borrowers who would be candidates for an IPO in a stronger market. The companies with the most compelling path to positive cash flows or an exit avoid a dilutive equity round that may be difficult to close. Lenders improve the characteristics of their portfolio at terms that are more lender friendly than in a strong IPO market.
Venture round structuring in a declining market puts more power in the hands of new equity investors. Competition for investments may be limited, allowing new investors to secure more favorable terms to reduce their downside and increase their potential upside returns to the detriment of the earlier investors.
In many cases, venture-backed companies will undertake all sorts of contortions simply to avoid the label “down round.” For example, for equity capital, liquidation preferences often receive seniority over earlier rounds and may come with preferences at multiples of the original issue price, with 1.5x-2.5x becoming increasingly common. Participating preferred shares with dividend rights and maximum participation caps reaching 3.0x or higher also become more common. New investors are also better positioned to negotiate for and receive prerogatives of control as a condition to close, wresting power away from founders and earlier investors.
These investments also come with more diligence attached.
Venture round structuring in a declining market puts more power in the hands of new equity investors.
And the In-Between
Existing investors may optimize deal structures between the good and less-good markets to maintain flat or up-round headline values relative to the previous round. Success in maintaining flat or up-round headline values to attract additional capital typically comes at the expense of more onerous rights and preferences than earlier rounds. This often means offering new investors more downside protections in the form of senior preference claims and other favorable terms, such as liquidation preferences at a multiple of the issue price, participation rights, and dividends.
The push to maintain or exceed prior round post-money valuations is usually driven by a desire to maintain the narrative and momentum surrounding the company’s progress. While this avoids the stigma of a true down-round, existing equity holders may fare no better than if the company had priced the round at a lower headline value and could do even worse if the market continues to move against them.
Where Are We Now?
In the current environment, some businesses may find themselves in the “in-between” space, while times are really not so good for others. A select few may still fall in the “good times” bucket, though that number seems to be dropping by the day.
Recent activity in the market suggests:
- Timelines to an exit are extending – 12 to 18 months of cash raised a year ago can only be stretched so far.
- All else equal, companies that did not raise at historically high valuations find themselves at an advantage when raising capital, given there is less need for complex structuring for a new round. They are less likely to negotiate with investors unable or unwilling to participate in additional funding rounds because they overextended prior rounds.
- Existing investors are seeking, when possible, to extend prior round financing on similar terms without participation from new investors demanding sharply different terms.
- Dominant investors are pushing for up rounds and forcing earlier investors to participate pro-rata to maintain their rights. Such pay-to-play rounds can force prior investors to convert their existing preferred shares to common or be materially diluted via inferior preferences if they do not participate in the new round.
What Does This Mean For Valuations?
While structuring to maintain a post-money value at or above the last round may help companies project a more desirable image, the impact on existing shareholders can be significant. We present two scenarios:
- The company in Scenario 1 is on a successful IPO path, having raised $100 million (post-money value of $300 million) in a round that was flat to its last round.
- Scenario 2 offers the same headline/post-money valuation as Scenario 1 but at the expense of favorable terms granted to the new investors (seniority, 2x LP, and 8% accruing dividends).
As the two scenarios show, structured financing provides significant value to new equity investors at the expense of those lower in the preference stack. Under one year to exit, investors in the new series will realize a 108% IRR (2x LP + 8% dividend). While earlier preferred shares realize their original preference but are junior to the priority claim of the new preferred, they face additional downside risk as a higher equity value is now required to satisfy a return on their investment fully. The common equity holders face an even worse outcome, as they have both an up-front loss of value and the risk of substantial losses as they only realize value at equity values that exceed the now higher level of liquidation preferences.
And the impact isn’t always just felt at exit. A rigorous valuation process should reflect the structure of subsequent financing rounds, typically through an option or scenario-based pricing model that captures the negative impact on earlier investors, all else equal, from the superior terms and preferences of the new round.
A challenging private market environment impacts more than the portfolios of investors in these companies. Discussions with VRC clients increasingly include complex valuation issues such as:
- Equity and earnouts issued as consideration in acquisitions (ASC 805)
- Goodwill impairment (ASC 350)
- Equity grants for compensation (409A / 718) issued by the portfolio company
- Lower threshold values at which grants may be issued in LLCs
- VC debt – enterprise value coverage and the impact of additional required capital and delayed IPO and M&A expectations on the debt and equity that may have been issued as part of the facility
- Lower values of LP and carried interests for gift and estate tax planning
For a more in-depth conversation, we welcome you to contact article authors Francis Mainville and John Swiatkowski or a member of your VRC Team.