Seizing opportunities in VC investing during this global ‘crisis’

20 Jan 2023 | Author: Tien Ma

The onset of winter doesn’t mean the death of opportunity, especially for those who know to look for growth signs.

A version of this story first appeared in Nasdaq. Click here to read it.

Early-stage venture capital (VC) investment has been one of the best-performing asset classes in the last few years. It has outperformed other private capital investments and eclipsed public equity benchmarks, especially on the back of the post-pandemic boom in dealmaking that defined most of 2021. However, 2022 seems to have been all about bringing these high-flyers crashing back down to earth, and the jury’s still out on whether 2023 will be more of the same.

Last year, investor hesitance over rising global inflation, the energy crisis and an uncertain geopolitical climate all came to a head when venture capital-backed funding rounds fell to pandemic-period lows. In July 2022, these rounds plunged by a staggering 65.6 percent year-on-year to just $21.78 billion – the lowest since April 2020’s $19.69 billion – and the number of rounds was also significantly less. With economists predicting an impending recession in the latter half of 2023, it seems like it’s not looking all sunshine and roses for VC investing any time soon.   

But despite the challenges and the ‘funding winter’ claims, there are still opportunities to be found in the current investing environment. VC investing has not dried up. The strategies have simply changed, notes Kelvin Tan, founder and CEO of Singapore-headquartered VC Origin Capital.

“Profitability has become our number one criterion in terms of deal sourcing as we make a conscious effort to move away from seed-stage deals to Series A/B companies,” he says. “To further mitigate our equity risks, we adopt a hybrid approach to private equity investing. Our term sheets incorporate short-term debt-like instruments, which yield liquidity and income for our investors, allowing for a more balanced risk-reward ratio on their cash deployed in this new environment.”

Additionally, the ongoing global crises also act as a test of fire to separate viable startups from the unviable. Coupled with the market downturn, this means that there are myriad diamonds in the rough now at attractive valuations – representing an excellent bargain-hunting opportunity for eagle-eyed investors.

Seamon Chan, managing partner at Palm Drive Capital, explains, “In a global economic downturn, the importance of unit economics in venture capital valuations cannot be overstated. While the potential for growth may be limited, a startup with strong unit economics is more likely to weather the storm and emerge as a viable investment opportunity in the long run.” 

Consistent consolidation in crisis

Leveraging crisis-born opportunities first requires familiarity with the current state of affairs, including the consolidation that we have been seeing happen at every part of the investing value chain this year. 

In stark contrast to the ‘wild wild west’ atmosphere of 2021, we saw VCs who focused on early-stage startups take more conservative positions in 2022. That meant writing smaller checks, consolidating their portfolios, concentrating on core positions, diversifying into familiar verticals and applying more stringent criteria for investment decision-making. They often did not make follow-on investments in startups who were not already profit-making or who were burning through cash too quickly.

Limited partners (LPs) also began to consolidate by eschewing investing in emerging fund managers in favor of the ‘safer,’ time-tested option: established VCs with a longer track record, experience in weathering different market cycles and strong cash reserves to fall back on. An unfortunate side effect of this was that newer, more diverse VCs lost out on funding, which in turn further shrank opportunity for atypical founder success.  

Startups naturally bear the brunt of a slowdown in investment deal flow, and tech startups in particular have been especially hard-hit lately with software valuations retracting to around pre-COVID levels. Many have had to make large staff layoffs to cut operating expenses, delay their IPO ambitions and put more experimental plans on ice as they attempt to wait out the funding drought.

Survival strategies

It can be difficult to see a silver lining against this gloomy backdrop, but perspective is important.

During the pandemic, we saw a proliferation of visionary startups that prioritised growth over revenue. These startups will now have to change their business model to prove that they can work in the present – not just to survive, but to convince investors that they aren’t just building castles in the sky. The successful startups will be more robust, resilient and disciplined, making them better investments.

In this climate, startups with proven track records will likely be more attractive to VCs as it’s easier for them to do their due diligence and make projections, which increases their likelihood of investment.

However, it can’t all be on the startup’s shoulders; VCs also need to support their portfolio companies by being more hands-on with them and providing advice and resources to help the startups navigate through current turbulence. Often, the VC is the one with the most financial and entrepreneurial expertise in the room – now’s the time to put it to use.     

Michael Sackler, managing partner of Supernode Global, notes,

“Through both the exuberant times of 2020 until the beginning of 2022, and now through this more difficult fundraising period, we have advised our portfolio to ignore the noise and focus on the fundamentals of the company. The best companies will still get funding.”

“Whilst we are undoubtedly in a very challenging environment, the fundamentals of how to build a successful company will never change: Surround yourself with the best talent, solve for a truly valuable problem, and execute better than your competitors,” he says.

Sackler also points out that “many investors are currently sitting on the side lines. This creates opportunities for those who are active right now to get into deals that they otherwise may not have seen.” 

My recent conversations with VCs particularly the European and U.S. funds have yielded one interesting observation: LPs have been asking how much of the VCs’ funds were deployed prior to March this year – when valuations were still high – and whether the VCs will invest after the downturn.

This signifies that they are able and willing to invest but are waiting to deploy at a discount – which is really just common business sense. VCs then have the job of showcasing the opportunities and discounts that LPs can leverage during this crisis; however, it must be backed with the proper due diligence.  

Fear not the storm

The term ‘funding winter’ is understandably popular in the right media now. It’s true that investor sentiment has been more bearish recently and check sizes have shrunk. However, a point to consider is that in some ways, fearmongering is deeply rooted within media economics. Crises and negativity are tied to audience attention and that’s why they’re being reported on. 

Sometimes you have massive deal sizes and skyrocketing investment, other times you have consolidation and smaller cheque sizes. That’s all part of the market cycle.

It certainly doesn’t mean that investment is non-existent; global impact startups, for example, still raised US$35B and surpassed 2020 numbers in 2022. Maybe instead of talking about a ‘funding winter’, we should look at the current situation as a form of correction of the VC investing ecosystem, placing it back in familiar and expected territory for investors. 

I have no doubt that it’s only a matter of time before spring returns for the early-stage VC ecosystem. When it does, those who seized the opportunities of winter will be the first to flourish.