VC Market Cycle: Shifting Investment Preferences throughout the Cycle
Unlike the stock exchange that reflects the aggregate performance of publicly traded companies and therefore more closely tied to leading macro economy indicators and the overall performance of the economy. The venture capital industry in contrast is operating in a different cadence and is affected by additional sets of factors, such as technology-driven shifts that drive market demand — the VC cycle.
The VC cycle doesn’t fluctuate in a pronounced manner like public markets, but it behaves in a similar sinusoidal fashion, consisting of 4 distinct periods of time from peak to trough which represent the change from expansion to contraction periods. These changes are driven by broad macroeconomic conditions such as interest rate, fundamental economic growth, stock market performance and others, which are all ultimately impacting the amount of commitments to risky assets, notably PE/VC funds. To see through these changes successfully, market participants from founders and investors aim to adjust their strategy from upside seeking or downside mitigation (from greed to fear), both to take advantage of current opportunities and protect from extreme scenarios. For a VC investor, the key amendments are conducted to selection criteria of the type of value proposition offered by the startup, business models, target customers, and ultimately the technology sectors of interest. These in turn have an impact on decision criterias and key KPI’s VCs look for, valuation benchmarks and the market realities such the due diligence time available.
One needs to remember that successful VC investors know to position their portfolios both to take advantage of times of peak valuations to increase their investment velocity, divestment activity and total ROI per each dollar, but at the same time also build positions in companies resilient enough to withstand long periods of illiquidity as a result of dramatic shifts in investors risk appetite.
Period A
Period A represents an environment that encourages risk taking, likely with low interest rates that encourages investors to exit the bond market and seek other classes that provide higher returns such as private equity and VC. These circumstances prevailed in the years 1996-1999 and pre 2019-2021. During these times, the technology sector is traded well at the stock exchange and software multiples are at an all-time high. In the immediate years prior to the burst of the bubble, tech markets can grow even 2–3x in a single year with companies shortening their fundraising cadence to a number of different rounds a year.
Tech companies that benefit the most are those that provide “growth supporting product”, in many cases sharing with their clients success, which resonates with clients that wish to capitalize on current market sentiment and beat their competition.
This gives rise to VC investment strategies that focus on sectors that are able to grow quickly in their “top-line” by raising more money “revenue return”, if you will allow, with no regards to actual expenses incurred and gross and profit margins. Thus the prevailing KPI is optimist seeking projection-based “Next Twelve Months (NTM) ARR Multiple”. Prior to the burst of the dot.com bubble, certain companies were judges by EV / Number of Eye Balls.
Although not offering much of a downside protection to speak of, Transactional business models are increasingly presented as “recurring & predictable”, and “Pay-As-You-Go” frictionless business model becomes more attractive as it allows scale and bigger upside.
Sectors that rise are Fintech and its payment derivatives such as HR tech, Proptech which benefit from volume of transactions. Another startup sectors that shine during this periods are semiconductors, agritech, climate tech, construction tech and other segments which typically require large development periods to be financed by investors but addressing large TAMs that can capture investors imagination.
Also companies that typically serve enterprise clients decide to go “down market” and begin to serve mid market and S&Bs to keep up with their competition growth rates. PLG companies that emphasize the “low touch” marketing approach.
During this time, due diligence of VCs is very limited due to competitive environments and some companies’ valuation makes no sense, like when it could reach amounts that are bigger than their TAMs.
On the extreme side, in this climate a few unusual phenomena start to emerge such as the emergence of Blank check companies (SPACs) and also crowdfunding investment structures that charge high fees (in some cases 50% and more!) “all in”. Due to lack of quality dealflow, some VCs look for regular businesses with large turn over that they could implement digitization and define it as “tech-enabled” and as such, command software-like multiples. This party is continuing until……
Period B
Tech companies with unsustainable business models begin to “blow up” causing a snowball effect of fear in the markets, and/or persistent inflation begins to emerge and central bankers decide to increase interest rates (what happened during Q1 2022). As a result, software public stocks drop sharply by 60–90% and multiples stand at a median of ~5x.
Despite the turmoil in the public market, private companies are not yet affected. Private companies’ valuations are still high. Also, companies are still well capitalized and do not feel an acute need for cash.
Many start to discuss a potential recession however there is no confirmed concrete data about reduction in customer appetite. This finds CEO’s in quite a flux, however some experienced founders begin to implement cost cutting initiatives that align their companies’ cost structures to the new and reduced sales projections.
Overall Investors and founders prefer to delay financial raises and are trying their best to grow into their valuations (although in many cases, unfortunately this is nearly impossible).
This period should be typically 24 months period and mainly characterized by investment standstill until private companies run out of cash and will have to readjust their private valuations to attract financings, and in the meantime, investors and LPs are sitting on the fence and only completed transactions they already started.
LP halt their investment in new VCs altogether (!) as they experience a “dominator effect” whereby their current allocation to private equity exceeds its target (due to fall of public stocks).
VCs shift their strategy to preserving the “winners” in their portfolios and in some cases, may buy shares at high valuations in their own portfolio (“internal rounds”) to avoid short term down rounds.These actions reinforce the mismatch between their fund’s reported valuation to real value.
Sectors of companies that are being hurt first are related to upside creation such as marketing automation, generation of new leads as sales and marketing teams are the first to layed off.
Due to the liquidity crunch, other sectors that experience harm that are the long term projects that are not critical such as AI analytics that have 3–5 years horizon as well as so called “deep tech” startups.
Companies that excel in this climate are companies that position themselves as “cost-cutters”, optimizers, and/or reduce risk such as reducing revenue and client churn. The software clients will not churn are the ones that serve as a source of truth of the oginizations, platform rather than point solutions, and that assist mainly the back office such as R&D.
The business models that are hurt first are the ones that have no minimum floor to revenues such as Pay as you go and transactional business models.
Companies that serve S&B’s experience significant churn and try to move up market.
During this time VC book value is impaired and does not reflect its intrinsic value as VC’s are obligated to update their valuations only when a transaction happens.
Period C
In period C, where LP commitments are renewed but overall allocation to VC is still trending down. During this period, interest rates are high, and LPs are more likely to increase their exposure in other asset classes such as bonds, credit, or real estate. As a result of reduced commitments to venture, VCs and founders are forced to make down rounds (or flat rounds with significant liquidation preference) to finance their operations at lower valuations, resulting in big losses and further contractions.
Early-stage startups are most affected during this period, as many companies will need to reach higher bars to raise financing. The time between their fundraising rounds is extended, and the ‘early adopter” customers, which are typically SMBs, reduce costs and software spend in key categories. Due diligence takes more time, as VCs struggle to reach conviction without proper “new world” historical performance.
Companies that serve government organizations as clients with long term agreement are receiving more attention as well as sectors that are perceived to be “mission critical” such as cybersecurity and infrastructure software. They companies business model is recurring and predictable and typically enjoy high NDR levels. These companies expenses tend to be attributed to COGS, or rather the operating system of record for organizations. Other value proportions that are being valued by the market are companies whose’ solution relate to shortening time to value.
Funds focus on downside mitigation although bargains may be found as software multiples are at 5x-10x, and are calculated based on Last Twelve Months (LTM ARR). This state of affairs continues until.
Period D
Recent positive track records generated by VCs in the new “normal world” valuation and interest rates are in the process of decline. In this period, LP commitments remain low but are trending upward. VCs can conduct more rigorous deal selection as they are more likely to adhere to their investment guidelines and many unsustainable companies and business models went bankrupt or exited the market. Many companies focus on “real-world metrics” such as profitability and cash flows. Interest rates are lowered, and companies start to decrease their debt burdens. The valuations of tech companies start to rise, making portfolios of VC firms that invested in period C look compelling, which attracts LP commitments. Investors shift their focus from profitability alone to a mix of profitability and growth to allow for upside. Software multiples for top companies are beginning to climb to >10x Current ARR.
VCs are more open to finance point solutions that can grow faster
Period E
Completing the cycle brings us to period E which is identical to period A. The stock exchange is performing well, and investors feel they have more disposable income and are more willing to take on risk. The level of LP commitments and risk appetite are once again high. Software multiples for select mediocre companies are likely > 20x ARR. Investors focus on growth at all costs.
It is important to bear in mind that overall, the market is trending upwards and that it is important for VCs to capture the fundamental growth of companies and markets. Understanding this cycle is critical, and identifying where we stand at different points in time allows us to try our best to time our entry to the market at opportune points of lower valuations and greater quality businesses.
