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The release of Pitchbook’s 2023 second quarter US VC Valuations Report raised some eyebrows when it showed down rounds—equity valuations at the time of a new fundraise that are lower than at the previous fundraise—at their highest level since 2017. This has left market participants wondering how companies and investors are reacting and whether there’s a light at the end of the tunnel. While others may be driving the train, we are certainly on board, equipped with a unique perspective of valuing hundreds of venture equity and debt positions every quarter.

Cash is King

In the current market, liquidity remains the paramount factor influencing a company’s ability to weather the storm. In recent years, companies typically initiated fundraising efforts with no less than six months of cash runway. However, even those who waited until the 11th hour were not significantly penalized, given the ample funding sources, including IPOs, SPACs, private rounds, and acquisitions.

Many of those fundraising options are less available today. For example, going public through a merger with a publicly traded SPAC—often at a higher level than was justified due to the incentives for SPACs to make acquisitions—was a viable fundraising strategy in recent years. However, these overvaluations have since come back down to earth, with PitchBook’s DeSPAC index plummeting over 70% in the past two years.

With SPACs mainly off the table, a largely barren IPO market, and private equity investors tightening their purse strings, pivoting from a “FOMO” bias in 2021, the market has become more investor-friendly, allowing them to extract concessions from healthy but cash-strapped companies nearing the end of their cash runways. This has forced companies needing capital to settle for down rounds/highly structured rounds, implement layoffs and cost-cutting initiatives, and significantly alter their growth plans to focus on achieving positive cash flow.

Non-performing companies face an even more dire fate, including wipeout rounds, selling at a fraction of previous valuations, entering into restructuring plans with investors and creditors (including bankruptcy), or simply going out of business. Such extreme cases are not yet prevalent. However, they may become increasingly common as sponsors and investors concentrate limited resources on “winners.”

In a favorable borrowing and funding environment, a successful round typically provides funding to reach a milestone or catalyst that supports a higher valuation, with a cushion of approximately six months. Depending on the company and industry, this typically translates to about two to three years of financing. Companies that missed the window of opportunity in the second half of 2021 and early 2022 are now reaching the end of their cash runways. For those that raised funds during that period, their runways are ending within the next six to 18 months, depending on the size of the round and their spending habits.

Adding to the complexity is that many companies raised funds in 2021 at what are now recognized as significantly above-average valuations, making it even more challenging to justify up rounds and flat rounds, even for those that have achieved significant milestones.

Battening Down the Hatches to Weather the Storm

As valuations across the VC landscape continue to soften and public exit opportunities become scarce, the primary response for most VC-backed companies is to batten the hatches through cost-cutting. This approach, however, is a double-edged sword: it curtails cash burn and extends runways but also significantly diminishes growth outlooks, consequently lowering valuations. Since a company’s value is dependent on its earnings potential, often simplified to a forward (often revenue) multiple (particularly true of growth and VC companies), these reduced growth projections—frequently from levels that may have been overly optimistic to begin with—can have a considerable impact.

While this is a significant concern for equity holders and corrodes LTV metrics, it provides some relief for debt positions. If companies can present a credible plan to achieve positive cash flows and service their interest payments while remaining on track to repay or refinance their debt at maturity, the situation may be less dire for debt investors.

The combination of sponsors and equity investors tightening their purse strings and the pullback of non-traditional investors (with the first half of 2023 seeing only $62.9 billion of VC deal value from non-traditional investors compared to $122.4 billion in the first half of 2022) means that cash-burning companies may find themselves without a lifeguard willing to jump in and save them. The onus is now on these companies to learn how to swim.

Successful companies, meanwhile, may be able to extend their runways by two to three more years or even turn profitable over time, eventually growing into the lofty valuations from their previous rounds.

Flat, Structured, and Down Rounds

As companies approach the end of their cash runways, an increasing number are reluctantly accepting down rounds, tapping existing investors for flat rounds, or engaging in structured rounds to survive. Approximately 15% of VC rounds in the second quarter of 2023 were down rounds, the highest level since the fourth quarter of 2017.

Several factors contribute to the prevalence of down rounds:

• Limited go-public opportunities, including a saturated SPAC market, a weak IPO market (with Morgan Stanley estimating that the IPO market won’t fully recover until mid-2024), and limited M&A opportunities.
• A pullback from non-traditional investors.
• Investors pivot in mindset from fear of missing out to wait and see, with the self-fulfilling opportunity created to invest at lower valuations as companies become more desperate for capital.
• Macroeconomic uncertainties include rising interest rates, geopolitical instability (such as the war in Ukraine), the potential for a recession, and persistently high inflation (though it has moderated from 2022 highs).

It’s worth noting that the number of down rounds may be artificially low, as some companies are holding off on raising rounds to delay marking down their values or are opting for flat rounds, which may depend on existing investors to provide financing until market conditions improve or profitability is achieved.

On the other hand, structured rounds feature favorable terms that protect newer investors in the event of a downside scenario while still allowing equal upside potential for all investors. Despite companies’ ability to advertise that they have avoided a down round, the reality, particularly in the case of structured rounds, is that they reflect down round characteristics when contract terms are considered.

For example, if a company raises a Series D round at $10 per share and has previously raised a Series C round at the same price, the headline suggests a flat round. However, suppose the Series D shares hold seniority over the Series C shares and have a liquidation preference multiplier that the Series C shares lack. In that case, the D shares are inherently more valuable, lowering the value of the Series C shares. This is akin to the effects of an unstructured down round.

As liquidity dwindles, the need for capital to continue operations will almost certainly drive additional down and structured rounds.

VC Debt as a Partial Solution

Debt financing allows performing companies to raise funds while waiting for equity market conditions to improve, thereby “saving face” from a down round. This approach enables companies to avoid substantial dilution, as warrants associated with new debt typically represent only a minimal ownership stake compared to what new equity financing would entail. If the assumption is a company can return to a higher valuation at a later date, debt financing can provide bridge capital until market conditions improve, thus preventing the dilution from a flat or down round.

However, there are limits to the debt alternative. While higher coupon payments may be favorable for lenders, they eventually reach a point where borrowers can no longer service the payments. It appears the market is approaching this tipping point if it hasn’t been achieved already. Debt may eventually price itself out of the market, making equity appear more attractive, even in the current environment.

VC lending also presents increased concerns as these companies lack the track record of withstanding economic downturns, which more mature companies can demonstrate. Moreover, with fewer exit opportunities to refinance debt (such as through IPOs or acquisitions), lenders must exercise greater caution and favor companies that can finance their debt to maturity.

Some IPOs and Up Rounds Offer Hope

On a positive note, there have been some encouraging developments in the VC landscape. In the first half of 2023, IPO US proceeds reached $10.1 billion, a significant increase from $4.7 billion in the first half of 2022 and $3.9 billion in the second half of 2022. IPOs also rose from 51 in the first half of 2022 to 63 in the first half of 2023. These figures suggest a promising trend in the public markets. There have been some headline IPOs in the back half of 2023, including Arm, Instacart, and Klaviyo, which, if successful, may help open the IPO market moving forward. However, it is worth noting that in some cases, valuations of recent IPOs (including Instacart) resulted in losses for later-round investors.

Meanwhile, though not as frequent as before, strong companies with favorable outlooks and conservative balance sheets have still managed to secure up rounds. Some companies are biding their time for a more favorable fundraising environment, seeking additional time to demonstrate their success rather than attempting to avoid a down round.

From an investor’s perspective, the market has become more accommodating, with companies that once demanded excessive premiums now offering more reasonable valuations.

Conclusion

In the current landscape of venture capital, it’s not realistic to expect a near-term light at the end of the tunnel. Challenges persist, and companies that have postponed fundraising will eventually need to raise capital. This may ultimately be a good thing, as valuations in recent years began to reflect unattainable growth estimates for even strong companies and perhaps kept weaker ones afloat longer than they should have been.

While some pessimists predict a massive awakening in the space, it’s important to consider that investors still have a vested interest in the success of their investments. Moreover, markets can be unpredictable, as demonstrated by shifting predictions about a potential US recession.

What is predictable? Strong companies with prudent financial management are likely to endure and eventually thrive, illustrating the resilience of the venture capital ecosystem.