Fintech – VC’s Hit By A Perfect Storm

Falling equity markets, flat bond markets, increasing interest rates and possible recession put Venture Capital at very high risk. 

The rapid whipsaw from the boom ‘at home trade’ of 2020, to rapid large interest rates rises (plus funding drying up) in 2022 is a real problem for all VCs.

Given the thesis on VC investment returns is a margin over interest rates - hasn't this just become much harder? 

Sentiment across the Fintech sector is one knifes edge with stock prices down on average 68% in 2021 and some sectors smashed. Just as concerning as declining inflows into VCs which will hasten decisions.

The IPO market has dried up so exits are now restricted to trade sales or mergers – at the same time start-up valuations are plummeting.

How Venture Capital Works

The venture capital (VC) industry has four main players:

1.   Start-up entrepreneurs who need funding for their ‘innovative idea’

2.   Investors who want high returns.

3.   Investment bankers who need companies to buy or sell.

4.   Venture capitalists who make money for themselves through fees, funding and by making a market for the other three.

VC niche exists because of the current structure and rules of capital markets.

A start-up with an idea or a new technology often has no other institution or bank to turn to. Banking regulation limits the interest charges on loans, ruling out most banks — and the high risks inherent in start-ups usually justify higher return rates.

Investors in VC’s are usually large institutions: pension funds, financial firms, insurance companies, hedge funds and university endowments/trusts. Investors expect higher returns given the very high risk. 

VCs raise money (new fund raisings) from investors and then seek to invest these funds in start-ups. VCs often specialise in industries or sectors and the amount of risk they take.

VC firms also protect themselves from risk by coinvesting with other firms. Typically, there will be a “lead” VC investor and several “followers” within start-up rounds.

VCs can specialize in different phases of start-ups e.g. early VC investors are called Angel Investors and often exit during early funding rounds – this is considered the riskiest phase with 8 out 10 start-ups failing. Others can be late-stage investors often dealing with Unicorns (start-ups valued over US$1 bn) which required much more capital.

In return for financing one to two years of a start-up idea, VCs expect a very high capital return. Combined with the preferred contractual position, this is a very high-cost capital: like a loan with a very high annual compound interest rate that cannot be prepaid! VCs count on the blind obsession and enthusiasm of start-ups.

The high return rate is necessary to deliver a targeted fund returns above 15-20%.

VC Funds are structured to guarantee partners a ‘comfortable’ income while they work to generate the returns.

VC partners agree to return the investors’ capital before sharing in the upside.

The VC fund typically pays for the investors’ annual operating budget, a small percentage of the pool’s total capital—which they take as a management fee regardless of the fund’s results. Funds are generally wound up when all investment outcomes are know which can be over many years.

Fintech is a major category of VC Investment

Fintech (which includes crypto) is the No 2 investment category for VCs

Fintech VC Investments are at All-time High

Total Fintech Investments 2008-18 were US$63.9 Billion which includes Venture Capital (VCs) and other investors including private equity and crowd funding, representing 6.7% of total start-up funding.

Since 2018 Fintech investments jumped to average $50 billion a year until 2021 which totalled a whopping US$131 billion. This is now set to decline as first quarter 2022 showed with early indications Q2 is declining further - this has real consequences.

The VC challenge now is turning around all the start-ups, changing their mindsets and ‘runways’ to fit the new circumstances – some gig!

VC’s Now Require Higher Returns

Inflation and higher interest rates mean VCs need to increase the returns they make given the high risks.

The major issue is VC have already invested large amounts in risky start-ups across Crypto, Defi, Fintechs and Biotech. These now need to perform even better than 6 months ago and tis will be a major challenge.

Venture Capital Feels the Stock Market’s Pain

Some companies are delaying IPOs as valuations fall and money gets tighter

WSJ By Lori Ioannou July 4, 2022

 The rout in the stock market has cast a shadow over the private-equity market, with valuations tumbling for many companies and some delaying plans to go public.

“Fears over the falling stock market, inflation and a potential U.S. recession have spilled over to the venture-capital industry, and multiples on mid- and late-stage valuations are rapidly compressing,” says Asheem Chandna, a partner at Greylock Partners.

Valuations aren’t down across the board. But venture capitalists say the situation is worsening for many companies as investors become more selective. “There is a flight to quality among investors,” says Andy Areitio, general partner at TheVentureCity, a global startup fund.

Mr. Chandna says companies’ business plans are getting more scrutiny and investors are looking for more evidence of financial health. “They are not solely valuing companies on revenue-growth projections; they are looking harder at a venture’s free cash flow,” he says.

Deal-making has slowed overall. U.S. venture-capital funds invested about $47.5 billion in 2,251 deals during the second quarter through June 15, versus about $70 billion in 3,369 deals in the first quarter, according to CB Insights. And in the secondary market for private equity, Forge Data says 55% of the equity offered for sale on its trading platform in May was offered at a discount to the companies’ valuations per share, compared with 47% in March and 35% in January.

Some venture capitalists say they are advising companies in their portfolios to shore up their balance sheets and focus on sustained growth to weather the economic turbulence ahead. Some companies are delaying plans for initial public offerings of stock.

VC Funding 

“Right now the timing is not right for us to consider going public,” says Naveen Jain, founder and CEO of Viome Life Sciences Inc., a maker of at-home tests for cancer and for gut and immune-system health. “We were exploring different SPAC [special-purpose acquisition companies] and IPO options earlier this year, but now we decided to wait and see how the market will evolve.”

Some venture capitalists are also rethinking their strategies. Falling valuations for many midstage and late-stage companies may prompt some cash-rich venture-capital funds to pour more money into earlier-stage companies to diversify their portfolio risk, says Jordan Levy, managing partner of SoftBank Capital NY and managing partner of Seed Capital Partners, an early-stage venture-capital fund.

But so far that hasn’t helped some early-stage companies. JonPaul Vega, co-founder and chief executive of Souq G-Commerce, an information and trading platform for owners of assets in web-based videogames, can attest to that. In early June, Souq closed a $3.3 million pre-seed round of financing, falling short of the company’s original funding goal. “We originally hoped to raised $4 million to fund beta development and the launch of our product, but over the last four months the landscape got more difficult, so we decided to close the round,” he says.

Joe DeWulf, co-founder and CEO of Novel, didn’t fare that well. In April he began a hunt for $1.5 million in pre-seed financing to expand a platform that lets brands add clickable action to video, including shopping. But he was turned down by 40 early-stage venture funds. “We learned during these hard times you have to get creative,” he says. “We turned to our loyal customers and angels for finance and raised $500,000.”

The bottom line: For many companies, raising capital will take longer and founders will have to adjust in this constrained environment. “Now is not the time to hide under your desk,” says Samir Kaul, a founding partner and managing director of Khosla Ventures. “It’s the time to be clever, shore up your balance sheet and prepare for an 18-month slowdown.” 

Start-up funding slump hits hard with 52pc fall in June

AFR Yolanda Redrup and Paul Smith July 5, 2022

 Venture capital investment in Australian tech firms fell anew in June, to be down 52 per cent from the year-earlier month and almost 10 per cent lower than in May, as local and international start-up investors bunker down for a prolonged downturn.

There were 44 deals completed in June, down from 63 this time last year, and they amounted to $408.6 million of investment, Cut Through Venture’s latest statistics show.

The largest round by more than $100 million was completed by education marketplace GO1, which closed a $145 million ($US100 million) raise in early June. Coming in second was fellow education tech company Edrolo, which banked $40 million in a Series B round.

OIF Ventures partner Laurence Schwartz told The Australian Financial Review investors across the spectrum were tightening the purse strings.

“A lot of investors – from angels to professional institutional firms are – slowing down deals and founders too are looking to extend runway until markets settle somewhat, and price discovery occurs, so we would expect the number of new deals to fall on both a numeric and dollar basis,” he said.

“There is a period of price discovery at the moment in the market. Valuation is both an art and a science and some of the market comparables and multiples have materially rerated in 2022.

“Growth at all costs is no longer being rewarded by investors and there is a shifting mindset towards businesses that have strong growth, but that are also capital-efficient, with strong underlying metrics like gross profit, sensible customer acquisition costs, lifetime value, retention and engagement.”

A survey of local VC funds by the Financial Review last week found that so far most had maintained their level of investment in 2022, but all were tipping a further slowdown in the second half. OneVentures and Blackbird Ventures, however, had meaningfully reduced investments in January-June, down 65 per cent and 43 per cent, respectively, on the year-earlier period.

Other funds such as Square Peg Capital and Telstra Ventures made substantially more follow-on investments into existing portfolio companies, rather than new businesses.

But, after a record-breaking 2021, in which major global investors including Tiger Global Management, Sequoia Capital, Horizons Ventures, Insight Partners and more participated in many of the sector’s biggest deals, offshore investment in Australian start-ups has slowed, contributing to the slowdown in value and number of deals.

“We are definitely seeing US VCs go slower on deals and in some cases (outside our portfolio) pull term sheets,” Mr Schwartz said.

Fitting with the substantial decline in later stage deals, more than 59 per cent of the VC deals closed in June were either seed, crowdfunding or small undisclosed rounds, Cut Through Venture’s figures show.

Climate and green tech companies dominated the investment volumes, with seven companies successfully raising funds, while the three education tech companies that completed new rounds made up 47 per cent of the investment value for the month.

While conditions are tougher locally for start-ups than they were last year, investors agreed that Australia was relatively better off compared with markets such as the US, where valuations had previously been substantially higher.

“The experience in the Australian venture market in recent years hasn’t been as heady as some of the large, offshore markets, where valuations were considerably more inflated and due diligence processes, at times, more light,” Main Sequence Ventures principal Gabrielle Munzer said.

“So while there is a sobering now, it is not being felt as acutely in Australia.”

The other big factor driving the reduction in local start-up funding was an evaporation of non-VC investors from the sector, including crossover funds and high net worth investors, said Carthona Capital partner Dean Dorrell.

These investors are often pinpointed by VCs as being responsible for driving up valuations last year.

“Late 2021 was a period that was completely out of step with normality – a lot of companies got funded at elevated levels and the demand was high. We have reverted back to the norm except that a lot of non-VC money has disappeared,” Mr Dorrell said.