Eugene Zhang, founding partner of Silicon Valley VC firm TSVC Spencer Green, general partner of TSVC
Courtesy: TSVC
Eugene Zhang, a veteran Silicon Valley investor, remembers the exact moment the market for young startups peaked this year.
The flood of money from venture capital firms, hedge funds and wealthy families pouring into early-stage companies is reaching absurd levels, he said. A company that helps startups raise money was oversubscribed at an absurd $80 million valuation. In another case, a small software company with just $50,000 in revenue received a $35 million valuation.
But that was before the turmoil that hit publicly traded tech giants in late 2021 began to trickle down to the smallest and most speculative startups. The heated market suddenly cooled, with investors dropping out in the middle of funding rounds, leaving founders powerless, Zhang said.
As the balance of power in the startup world shifts back to those holding the purse strings, the industry has settled on a new math for founders to embrace, according to Zhang and others.
“The first thing you should do is forget about your classmates at Stanford who raised money in [2021] ratings,” Zhang tells founders, he told CNBC in a recent Zoom interview.
“We’re telling them to just forget what happened in the last three years, go back to 2019 or 2018 before the pandemic,” he said.
That equates to valuations roughly 40% to 50% off their recent peak, according to Zhang.
‘Out of control’
The painful adjustment roiling Silicon Valley is a lesson in how much luck and timing can affect the life of a startup—and the fortunes of its founders. For more than a decade, larger and larger sums of money have been thrown into companies across the startup spectrum, increasing the value of everything from small, for-profit outfits to still-private giants like SpaceX.
The era of low interest rates since the 2008 financial crisis has spawned a global search for yield, blurring the lines between different types of investors as they all increasingly seek returns in private companies. Growth was rewarded, even if it was unsustainable or came with a poor economy, in the hope that the next Amazon or Tesla would emerge.
The situation peaked during the pandemic, when “tourist” investors from hedge funds and other newcomers piled into big-name venture capital-backed funding rounds, leaving little time for due diligence before signing a check. Companies doubled and tripled their valuations in months, and unicorns became so common that the phrase became meaningless. More private US companies reached a valuation of at least $1 billion last year than in the previous half decade combined.
“It’s been kind of out of control for the last three years,” Zhang said.
The beginning of the end of the party came in September, when stocks of pandemic winners including PayPal and Block began to fall as investors anticipated the start of Federal Reserve interest rate hikes. The next hit was the pre-IPO valuations of companies including Instacart and Klarna, which tumbled 38% and 85%, respectively, before the decline eventually reached early-stage startups.
Deep cuts
As hard as they are for founders to accept, valuation cuts have become standard across the industry, according to Nicole Wischoff, a startup executive turned venture capitalist.
“Everybody’s saying the same thing: ‘What’s normal now is not what you’ve seen in the last two or three years,'” Wischoff said. “The market seems to be marching in saying, “Expect a 35% to 50% valuation decline from the last couple of years. This is the new normal, take it or leave it.”
In addition to headline-grabbing valuation cuts, founders are also being forced to accept tougher terms in funding rounds, giving new investors more protections or more aggressively diluting existing shareholders.
Not everyone has embraced the new reality, according to Zhang, a former engineer who founded venture firm TSVC in 2010. The company made early investments in eight unicorns, including Zoom and Carta. It usually holds its shares until the company’s IPO, although it sold some positions in December ahead of the expected decline.
“Some people don’t listen, some people do,” Zhang said. “We work with the people who are listening, because it doesn’t matter if you raised $200 million and later your company dies; no one will remember you.”
Along with his partner Spencer Green, Zhang has seen boom and bust cycles since before 2000, a perspective that today’s entrepreneurs lack, he said.
The founders, who need to raise money in the coming months, must test the appetite of existing investors, stay close to customers and in some cases make deep job cuts, he said.
“You have to take painful measures and be proactive instead of just passively accepting that the money will show up someday,” Zhang said.
A good harvest?
Much depends on how long the downturn lasts. If the Federal Reserve’s campaign to fight inflation ends sooner than expected, the money spigot could reopen. But if the decline continues into next year and a recession hits, more companies will be forced to raise money in a tough environment or even sell themselves or close up shop.
Zhang believes the down cycle is likely to be prolonged, so he advises companies to accept valuation cuts or down rounds as they “could be the lucky ones” if the market turns even tougher.
The flip side of this period is that bets made today have a better chance of becoming profitable in the future, according to Green.
“Investing in the seed stage in 2022 is actually fantastic because the valuations are adjusted and there’s less competition,” Green said. “Look at Airbnb and Slack, Uber and Groupon; all these companies were founded around 2008. Recessions are the best time to start new companies.”