022 has undoubtedly been a very eventful year for venture capital.
After a massive couple of years following the start of the pandemic, conditions have begun to normalize with higher interest rates and a bleak economic outlook. This has led to a huge sell-off of public tech stocks, which has spilled over into the private markets as well.
With so much going on right now, VCs and investors should do their best to keep running tabs on the broader industry, which will ultimately help shape their own investment strategies and decisions.
One way to do this is to follow the bank SVB Financial, which is the parent company of Silicon Valley Bank. SVB has been banking the startup, venture capital, and private equity communities since the 1980s so they have a great pulse on the ecosystem as a whole.
Additionally, SVB’s client inflows typically encompass about half of all U.S. VC investment activity, so management has a ton of up-to-date and insightful data about the industry. They recently reported its third-quarter results, which consist of the months ranging from July through September.
Here are five things we learned about the state of VC from SVB Financial’s third-quarter results.
1. U.S. VC investment has slowed
This one probably isn’t a huge surprise, but U.S. VC investment activity significantly slowed in the third quarter of the year, totaling only $43 billion. This is the lowest level seen since the fourth quarter of 2020.
That’s down from $72 billion in the second quarter of this year and from $90 billion year over year. The culprit, according to SVB’s management team, is “prolonged public market volatility.”
Still, VC investment in 2022 through September has exceeded all past years excluding 2021, which is a tough comparison, so overall it still looks quite healthy even though it’s certainly trending downward. SVB’s Chief Financial Officer Daniel Beck said at the top end of the bank’s range it expects VC investment activity in the US to be similar in the fourth quarter as it was in Q3.
2. Cash burn is still very high
A big problem in the industry is that while investment is slowing, startups are burning through cash at much higher levels than they were prior to 2021 and way above pre-pandemic levels.
The good news is that cash burn among SVB’s clients slowed in Q3 from the prior two quarters. The bad news, however, is that it’s still at two times the level seen prior to 2021 and has not adjusted to the lower levels of fundraising yet.
Greg Becker, CEO of SVB said that right now it’s difficult to understand cash burn trends. Part of that dates back to the beginning of the pandemic in 2020. In the early months when people didn’t know how long broad swaths of the economy would be locked down, companies were cutting costs heavily only to see a major bounce back – and then a golden age for VC and startups – just three or four months later.
Then, a lot of startups raised an incredible amount of money, enough for three or four years of runway. Many of these startups are still performing well and don’t see the need to cut costs, so they are still burning cash. But Becker also said (after attending a CFO summit for VC and PE companies) that many believe the outlook has gotten worse and are telling companies to cut their costs, which would slow cash burn.
Becker believes cash burn will continue to drop from here but that it could take two to four quarters to get back to levels seen in 2021.
3. There’s still an incredible amount of dry powder
VC investment may have slowed but the industry is still sitting on a lot of cash in its coffers that is specifically slated for startup investment. At the end of the third quarter, global VC dry powder still sat at a record $557 billion, roughly $180 billion higher than the end of last year. PE dry powder sits at an incredible $1.95 trillion.
In a note to shareholders, Becker said the “bank’s conversations with clients suggest they are positioning themselves for a rapid resumption of activity once the broader markets stabilize.”
4. Less down rounds and more structured rounds
Becker said he’s not seeing a lot of down rounds yet when companies accept lower valuations, which one might expect given how much the valuations of large public tech companies have come down.
But he did say he’s seeing a lot of structured rounds where the valuation stays the same but the investors might get double the liquidation preference. During a structured round, investors come in and give a company money in order for the startup to maintain its operations and (hopefully) continue to grow.
The investors then get senior preferred stock, which is paid out before other investors and usually has a dividend or cash component where the investors are receiving interest on their capital. Existing investors may also be interested in this because it also hurts them if the company takes a down round. But at the end of the day, structured rounds typically occur when valuations are too high and aren’t exactly good for the founders or other existing investors.
“There's always a debate when you sit down with venture capitalists, some would say, never do a structured round, take your pain, your medicine and lower the valuation to the market, raise money when you can,” said Becker. “And others would say, protect your valuation if you can keep it and do a structured round. It's not the end of the world. So, we're just seeing that all play out.” To be clear, this doesn’t mean down rounds won’t happen just that not that many have happened yet.
5. The innovation economy is still larger than it was
The innovation economy has now shrunk since its peak in late 2021 but it’s still considerably larger than it was pre-pandemic when the innovation economy made up just over 10% of U.S. gross domestic product (GDP). Although this is not to say that it couldn’t continue to shrink.
According to SVB, the digital economy grew at 2.4 times the pace of the overall U.S. economy between 2000 and 2020, and the pandemic has accelerated the pace of digital adoption.
Furthermore, despite the outflows of client funds, SVB still added a record amount of new clients to the bank in Q3, suggesting that startup creation is still strong. Coupled with the amount of dry powder, the sector appears well-positioned to resume its positive momentum once volatility in the public markets subsides.
Even with the drop off in venture capital activity from 2021, 2022 still ranks as the second-highest investment year in history, probably settling around $225 billion for the year.
Still, there remains significant amounts of dry powder available to fund startups. This stands as a strong opportunity for some of those breakthrough companies to shine through. True leaders often break out of the pack during tough times and we expect that to happen over the rest of 2022 and 2023.
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