Is the party over for early stage VC investment?

There is less appetite among early-stage venture capital (VC) investors for companies that burn cash with a narrow path to profitability, writes UNSW Business School's Mark Humphery-Jenner

Recent valuations have come under significant pressure for both listed and unlisted firms. The broader tech sector has lost significant value during 2022. This has filtered into private capital markets where valuations have fallen. This includes early-stage startups and later-stage companies, such as Canva. Startup valuations are estimated to have fallen at least 25 per cent, on average.

However, many prominent firms started life during downturns. VC funds still have dry powder to invest in. Angel Investor groups – such as Sydney Angels – continue to support startups. Thus, we need to look at how the downturn impacts firms, what to look for when investing, and how the downturn will impact VC funds.

Why are valuations coming under pressure?

This is because of multiple factors. Any firm’s value is simply the present value of all future cash flows. The discount rate increases with interest rates and risk. Recession risk plays a role. Recessions are associated with lower consumer and corporate demand; and thus, lower cash flows. For startups, a recession can cause an otherwise good company to fail before it finds the footing that it might otherwise have achieved in good market conditions. Additionally, startups’ cash flows are more distant. Thus, they are discounted more. Therefore, the structural shift upwards in rates and recession risk reduces valuations.

Are there still opportunities for VC investment?

There are many investable early-stage companies. However, it is important to focus on quality growth. Anecdotally there has been a focus on earnings (i.e., net income) and free cash flows rather than on revenue. However, regardless of the company’s life stage, this environment has several considerations. A non-exhaustive list is:

1. Look at the company’s path to profitability. Consider whether the plan is cohesive. Consider whether the firm has a genuine defensible advantage and can survive consolidation.
2. Consider the firm’s cash runway and burn rate. That is, how much is the company spending and how long will it last before needing more capital. You want to ensure that an otherwise good startup does not run out of cash before it can grow.
3. If the firm is unprofitable, and/or is reinvesting cash, what is the return on invested capital (ROIC)? And, is that ROIC sufficient to generate growth?
4. In an inflationary environment, does the firm have pricing power and/or sticky customers? Does the firm need to continue with significant expenditures that are continuing to increase in cost? Does it require significant CAPEX, or R&D, both of which can reduce cash flows? Or, has the firm made the bulk of the ‘large’ foundation expenditures?
5. How exposed are the firm’s cash flows to rising interest rates? If the startup has no debt, then rising rates mainly influence valuations through their revenue impact, the discount rate and expectations about future access to debt.
6. Ensure that the firm has strong management. In tough environments, excellent corporate governance can help a firm dominate its rivals. Ensure that the managers will focus on shareholder wealth maximisation, rather than on extraneous fluff. Early-stage investors can better achieve this with board rights and appropriately incentivising the founder.

In all cases, there has been a greater emphasis on the firm having an adequate plan. Pie-in-the-sky ideas have generally lost support.

Read more: How investors and entrepreneurs can successfully play the forecasting game

Is there value in ESG?

ESG is the elephant in the room. ESG had been in vogue, however, it has come under significant scrutiny. The focus now is on precisely whether, and how, any of the ESG components create value.

ESG considerations are relevant to the extent they influence cash flows and/or risk. It is important that investors not be sucked into trendy grandstanding based on junk science. There is fluff in the ESG investment space. This is evident in the considerable divergence between ESG indexes. And, a tough financial environment is even more unforgiving to fluff. Many of the relevant factors are similar before, during, and after economic headwinds.

Thus, “ESG” is relevant where it impacts profitability. For example, it is important to focus on corporate governance that maximises shareholder wealth. Environmental considerations can influence cash flows. And, they can provide considerable opportunities. But, each investor must consider each opportunity on its merits.  

How will this impact VC funds and early-stage investors?

The impact on funds depends on the fund’s stage. A typical VC fund lasts for 10 or more years. It spends the initial first few years making initial investments. It spends the middle stage supporting those companies and investing in follow-on rounds. The VC fund will spend the final few years ‘exiting’ investments by either selling them to other companies or listing them on the market.

Nascent VC funds can benefit from the downturn. New funds have a long time horizon. Thus, they will invest at low valuations now, knowing that downturns are part of the economic cycle. Indeed, lower valuations can present opportunities.

Older VC funds – nearing their portfolio horizon – could suffer in a downturn. This is because valuations have fallen, on average. However, these VC funds must look to exit their investments. This can create problems. Either the VC fund will need to seek a time extension from its investors, will need to sell its stake to other investors, and/or might need to accept a lower valuation upon exit. However, much will depend on the specifics of the company.

Read more: Need crowdfunding? 6 steps to success for entrepreneurs

Where does this leave the future of VC investment?

VC investment will continue to occur. Early-stage investors still have an appetite for deals. They know that the economic cycles are normal. However, they will focus on companies with quality earnings that are well-positioned to survive – and thrive – in the present economic climate. And, there is likely less appetite for companies that burn cash with a narrow path to profitability.

Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals and his research interests include corporate finance, venture capital and law. For more information please contact A/Prof. Humphery-Jenner directly.