Data is yet to capture the full extent of the ‘valuation reset’ across late-stage VC, while lower valued early-stage start-ups could face consolidation…
Late-stage VC has been hit hardest by the reset in valuations, with the number of high-profile examples snowballing through 2022.
At one point last year, payments start-up Stripe was the most highly valued VC investment in the US. Last month its valuation was slashed by 64% by one investor. Weeks earlier, valuations were cut at Swedish buy-no-pay-later fintech Klarna, following delivery app Instacart before it.
“The startups that enjoyed sky high valuations based on hype and ‘FOMO’ are the ones that will feel the brunt of the downturn,” says Nic Brisbourne, CEO and managing partner at London-based VC firm Forward Partners.
“While there has been a recalibration of valuations, this also reflects the fact that many of the impacted companies were overvalued. Now the market has a chance to normalise, and investors can sift out the hype and froth. This has been painful for many companies, but it’s prompted an important exercise; startups and their investors are working out whether they can justify valuations and are evaluating the robustness of business fundamentals.”
With an IPO in their sights during 2021, many late-stage start-ups now face more pressure to justify high valuations as public market equivalents have crashed.
UK-based digital bank Zopa had planned to go public this year, but in July, the CEO told one reporter: “The markets have to be there [and they are] not there — not for fin, not for tech”.
First-half data from 2022 is yet to show the full extent of the damage to late-stage start-up valuations. During H1, US median late-stage deal value fell only 7.1% compared to 2021, according to PitchBook’s latest valuations report. In Europe, late-stage valuations and round sizes paced above 2021 figures.
More falls are expected in H2, given the widespread uplift in valuations over the past few years. In a Private Equity Wire survey in July, over half of all respondents (53%) expected to see a markdown in the valuation of their VC investments in 2022, compared to 2021. Eighty percent of investors still view venture capital as overvalued, according to a Preqin survey of 300 LPs in June.
Disciplined returns
According to Natalie Hwang at Apeira, the significant influx of capital into private markets has led to aggressive growth and equity multiples for many start-ups, which can create a wide range of assumptions in pricing and valuation risk.
“We’ve been cautious to the risks of investing in companies on prices that we believe are over driven by momentum versus underlying fundamentals,” she says, “because they can price at a number that far exceeds their actual realisable liquidity values, and subsequently fail to yield desired returns and investors can be seeking. But as the pool of potential buyers diminishes, caused in part by the rotation of non-traditional investors outside of the asset class, we are seeing more disciplined valuation practices begin to take place across the sector.”
According to data from CB Insights, the average increase in valuation between all financing rounds has been trending down since the end of last year. But look more closely… The valuation uplift in the growth stage of the market was around nine times over the past five years, says Ed Knight at Antler, compared to around two times in the early stage. Will the full ‘reset’ be proportional to the uplift, as it trickles down to early-stage VC too. The Q2 median pre-money valuation for early-stage VC in the US fell 16.1% quarter-on-quarter, according to PitchBook data. In Europe, early-stage valuations paced above 2021 figures in H1 2022.
Early-stage impact
According to Stephanie Choo at Portage, early-stage valuations have shifted from “easily in the $20m-$30 million range, up to $50 million last year”. In the current market, they are dropping to low teens and high single digits, she says.
The opportunity here may be for VC fund managers to bolt-on undervalued start-ups to their existing investments. Some start-up founders have said publicly that a wave of consolidation now seems likely among late-stage fintech start-ups, if the IPO window remains closed.
“I expect acquisition opportunities to continue to increase through the next two years as companies want to exit and can’t exit through the public markets,” says Choo.
Seed stage valuations are holding up and have not fallen from the previous quarter since the onset of the pandemic. This was attributed by PitchBook to the high participation of non-traditional investors and micro-funds still active there.
Lower start-up valuations and funding rounds ultimately impact VC fund performance and investments made by VC funds at booming valuations will have to perform even better to deliver target returns to investors. The median VC fund that was raised in 1996, as the internet boom was just gathering steam, returned over 40% a year over its life. After the dot com crash, US VC 1999 vintage year funds still report an overall negative internal rate of return in most data sets.
Over the last five years, VC has shown a 29.5% internal rate of return, nearly double the annualised rate over the trailing 15 years. This seems unlikely to continue.
PitchBook’s preliminary benchmark quarterly IRR for VC in Q1 was negative – this is only the second time it has moved into negative territory in seven years, excluding the onset of the pandemic in 2020. But while VC funds above $250 million in size follow the broader market, funds below $250 million have outperformed and remain at historically elevated levels, by rolling one-year horizon IRRs [see chart above].
“We believe we will continue to see a decline in VC fund valuations over the coming quarters as the reality of a slower growth environment sets in and public market valuations settle,” says Dan Aylott at Cambridge Associates. “However, venture capital is a long-term asset class and experienced GPs will be focused on helping their companies and entrepreneurs through these challenging times, so that they can take advantage of the upswing when it comes. We have confidence in the long-term outlook for venture capital globally, but there will be some bumps in the road in the near and medium term for sure.” 
