As recessionary times start to bite, what do VCs look for?

Founders are increasingly getting the message from the global VC industry that their valuations have changed significantly since the US tech sharemarket crash and due to general recessionary times, says Lance Wiggs.

“Most people if they’re investing more money into your company, it may not be anything like the last valuation but a lot of people are simply holding off investing,” says the co-founder of 2040 Ventures, manager of the Punakaiki Fund and Climate Venture Capital Fund.

VCs have turned off the tap to a large extent and are doing mainly follow-on funding to their existing portfolio, adds Wiggs.

Vignesh Kumar, a partner at Global from Day One (GD1), says our local market didn’t experience truly dizzying valuation drift like in the US “so our valuations aren’t as toppy”.

“That said, there was still some drift and so valuations converging lower is now expected. In terms of impact, I think if companies raised their last rounds at the height of late 2021 or early 2022 then there will likely be some cognitive dissonance between multiples for the last round and the new round,” he says. 

The net result is a lot of startups will be taking a meaningful haircut to valuation for any imminent capital raises, particularly if they only have a short runway before they run out of cash and their need is urgent, he says. 

Valuations have dropped by significant percentages in the US – varying from 20 percent to 40 percent – and less in New Zealand where they didn’t reach such frothy heights, says Ngaio Merrick, managing partner at Nuance Connected Capital.

She works with startups to forecast future follow-on rounds, their quantum and where the funds may come from. “Valuation focus on investment is strongly tied to potential fund returns, the percentage holding and future rounds. We’ve definitely seen more realistic valuations from founders and boards in the tight market and we welcome that change.”

Carl Jones, co-leader at WNT Ventures, says the revenue or profit multiples at which investors have been assessing companies have fallen dramatically. Nothing demonstrates this as clearly as the Bessemer Ventures Cloud Index metrics, which fell from a top quartile high of 24.55x in February 2021 to a low of 8.46x in August 2023 (and 3.47x for the bottom quartile). 

Startup founders will need to find metrics that are relevant to their company, which Jones says is  probably one of the key changes in recent times.

“Knowing how investors may look at the later stages of your company’s maturity will give you insights as to how they might view your valuation in the early stages.”

Caffeine asked all four VC managers what they’re looking for from high-growth startups in the current climate. Merrick says while requirements from startups haven’t changed, there are “nuances as we look to mitigate new market risks”.

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Here are their 10 key points:

1. Runway is king 

The highest level of additional scrutiny in the current climate is on ensuring all extraneous spending that’s non-essential for growth has been cut back to minimise cash burn and extend the runway, Merrick says. “When fundraising becomes more difficult, runway is king.” It gives founders more options, prevents them having to take predatory downrounds and provides time for critical product and customer inflection points to increase valuations, she says. 

Kumar says GD1 issues the clear instruction to its portfolio companies to work hard on capital-efficient growth, and to focus ruthlessly on the business’ overall viability and the ability to unlock strong unit economics alongside a robust operating cash runway.  

Wiggs advises founders to save money where they can, including downsizing staff if necessary, and not do an automatic next round. Instead, try to hold out for a better valuation. Companies that are doing well don’t really need investment but can go to investors to speed up their growth, he says. “We like to back companies where our money will make a difference but they don’t need to raise incredible amounts in the future.”

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2. Be resilient 

Nuance has always sought out (and found) founders who are passionate, self-aware, coachable and resilient, Merrick says. “The passion to survive in tight times has to be unyielding”, she says and founders need to be more open to being coached towards success when things don’t go their way.  Merrick says she digs deeper and asks more questions about how founders have handled prior crises to ensure they have the tenacity to both survive and succeed.

Kumar says GD1 looks for founders who have the grit and resilience to keep their businesses going during hard times. They also look for founders with the self-awareness and mental agility to make the necessary, and inevitably hard, changes to respond to challenging economic conditions. 

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3. Consider return potential 

Investors are intrinsically motivated by financial returns as they have their own investors, and funds will seek a multiple on their investment, says Jones. The multiple can be sector- (Saas vs medtech) or stage-dependent (seed vs Series A) and commensurate with the risk taken. 

“Take into account the future dilution on the investor. You need to understand the capital required to get where you are going and liquidity pathways, i.e. will you be dividend producing, bought by a trade buyer or going to IPO in X years’ time? All these need to be realistic and provide an investor with an idea of what their investment could be worth in the future,” he says.

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4. Strong team

Everyone wants a strong team, especially the C-suite, but what’s become even more apparent in the current market is that removing weaker team members is distracting and expensive, says Merrick, while finding new capable team members often means looking offshore. “The recognition that new team members have a settling-in period before they hit their straps compounds the effort and financial risk of not having a strong team from the get go.”

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5. Price for inflation

A lot of founders haven’t experienced high inflation before and have to learn how it works, says Wiggs. Due to inflation on the input side, they need to factor in more frequent price increases or they won’t make sufficient profit. “There is the risk of an inflation spiral, but if your product is delivering good value then clients should be happy to live with the price changes,” he says. Many of the Punakaiki portfolio companies have pricing power and, in general, inflation gives them the ability to raise prices as customers understand, he says. 

6. Traction

Consider what traction means to you and whether it’s always more revenue, says Jones. In deeptech, for example, a company may not be revenue producing within three years but it has hit all its R&D, regulatory and commercialisation milestones that will secure an uplift in value. “Being able to provide investors with insight as to what drives value in your industry shows your depth of knowledge about what you are doing and that you have thought deeply about the market opportunity,” he says.  This provides investors with greater insights into potential liquidity pathways, which feeds back into their own return analysis for their backers.

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7. Go-to-market strategy 

Merrick says Nuance researches and considers the geopolitical landscape of the global target markets a startup intends to enter. Compliance laws, sector-specific government mandates, international fundraising opportunities and cultural acceptance all play a part. When investing in a Series A round, Nuance also looks for traction in international markets – proof that customers in those markets want and are paying for the product and services. In the current environment, Nuance is looking more closely at whether a startup’s market is still accessible, as well as whether the customer conversion process is not too complicated.

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8. Clean cap tables

Merrick says Nuance has always preferred clean cap tables and it would previously be worth the extra effort to work with the founder and existing shareholders to ‘clean up’ the cap table if there was a drag from a former founder, dead weight to too many small shareholders. “These days, given how much harder it is to raise funds, we’re less likely to pick up a cap table which needs significant work,” she says. 

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9. Investor-portfolio fit

Jones says founders are not just competing for investor capital with new companies in a particular portfolio but with the fund’s existing portfolio companies. Before approaching an investor, founders should understand the investor’s sectors of focus and if they are looking to go deeper into that vertical or double down on their existing portfolio instead. 

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Kumar says GD1 has a “meaningful amount” of capital reserved for follow-on within its fund. However, “we are also super judicious with our follow-on capital strategy and our companies and founders have always been aware of that”. “We will continue to keep supporting our companies where we can” and on the new investment side, given the watermark for performance is rising, GD1 is increasingly saying ‘no’ to new investments that don’t meet this threshold. “In this sort of market, optimising capital allocation and weighing up opportunity costs becomes a much bigger decision driver for the VC market,” he says.

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Wiggs says sometimes companies can go through a bad year or two and that’s okay, providing their fundamentals mean they will bounce back. “One of the things about VCs is they only want to invest more into the ones that will pay off the funds – the ones making really high growth rates and making great returns – but we have several companies that are growing annually at 30 percent to 50 percent a year, and doing it year after year.”

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10. VCS need funds too

Venture funds need to raise a new fund every few years, says Jones. “Always check to see where a fund is in their lifecycle, how much capacity they have left, and whether they are raising a new fund,” he says. Funds raising Fund 3 or 4 will be having an easier time in the current environment than those raising Fund 1 or 2, given the former will have a track record to prove they are worth investing in, he says. “Limited Partners [investors in VC funds] are much more cautious about investing in unproven VCs right now.”

Some fund may have been caught out by downward valuations, which makes it harder for them to then raise more as a VC, says Wiggs. “It can be brutal to do so in New Zealand.”

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