Market correction & early-stage private equity

Insights 0001 Market Correction

Over the last decade US public markets have boomed and the market caps of technogoly stocks have risen consistently. This environment created a frenzy of venture capitalists (VC) looking to strike gold with the next big technology IPO. From Series A to pre-IPO funding, tech startups appeared to have access to limitless inexpensive capital. And technology VCs and growth equity investors (unlike their private equity counterparts) were far more focused with finding the next big tech company as early as possible than they were with accurate valuations and capital efficiency. As a result, the global VC investment market reached a value of US$ 197.7 Billion in 2020!

After more than a decade of strong growth in the US market, the fairytale came to an end in 2021 when rising interest rates led to a major correction in the public markets, and in particular technology stocks. This drop in value has forced all technology investors, from early stage to growth stage, to rethink valuations and prioritize capital efficiency in private investments.

As a result there is now a small but ever-expanding group of Early Stage Private Equity investors looking to leverage the capital invested in early-stage ventures, and repurpose it effectively to build a profitable and sustainable business. Instead of striving for growth at the expense of business fundamentals in the hopes of one day reaching an IPO, the goal is now an exit to strategic or financial buyers looking to acquire stable technology companies with predictable revenue and cash flow that can be scaled.

We at Stage are one such Early Stage Private Equity firm looking to seize the opportunity presented by the growing number of early stage technology companies in need of capital after losing venture funding. Rather than wasting the valuable innovations that have resulted from the explosive growth in VC and venture debt of the last decade, early stage PE investors like Stage are taking companies that have fallen off the venture path and are showing them a way to a profitable future.

Early stage investment landscape

2020 and 2021 saw a record U$150 billion invested into early-stage technology companies globally. The amount of each investment increased, with the average Series A round investment jumping from under $6 million to over $18 million. When you add in seed round funding, an early-stage startup could have easily raised over $20 million just to build a product and secure initial customers. Valuations skyrocketed during this period, with companies raising money at 10-20x revenue, something that can only be justified if the company continues to grow at over 100% year on year.

And yet, amidst this investment fervor, roughly half of Series A companies fail to raise a Series B round, taking them off the venture path. This is by design: venture funding relies on top performing investments (or “unicorns”) to deliver fund returns, despite the fact that only 2% of seed-funded companies will achieve this level of success. VCs are constantly moving around the capital in their portfolio to put towards those companies with the potential to deliver an outsized return. They encourage portfolio companies to take on additional debt to spur growth, hoping the capital will be recouped when the company is sold, despite the added liability for the company. The messaging to founders is clear: grow the company (at all costs) or lose funding.

Market Correction Impact

CB Insights’ State of Venture Q2’22 Report found a 23% drop in VC funding to startups on a global level in the second quarter of this year, with $108.5B raised across 7,651 deals. This was the second largest quarterly percentage drop and the largest quarterly percentage drop in deals in the past decade. 

Data released by PitchBook confirms that early-stage VC valuations saw a sharp decline in the second quarter, with very few unicorn public exits in the first half of 2022.

All of this data suggests that early stage venture funding has decreased in 2022. However, the decline should be short-lived, as venture returns are largely uncorrelated to public markets and have performed well over time. Major asset managers like Battery Ventures, Lightspeed, and B Capital are announcing huge new funds, signaling venture funding’s promising future.

In the meantime, the market is correting itself and valuations are on the decline, allowing early stage private equity investors like Stage to get a great deal.

Early-Stage Private Equity

What is it?

Early Stage PE gives founders an alternative path to traditional growth equity. Early Stage PE investors acquire a controlling interest in emerging technology companies that have a good product, customer traction, and a fundamentally profitable business model and change the management approach to focus on business fundamentals rather than growth at all costs.

Early Stage PE Funds – including Stage – leverage the capital that has been invested in early-stage venture, and repurpose it effectively to start a new journey for the company from a solid foundation. Capital efficiency is prioritized and a huge upside potential is created (a company’s value grows exponentially once it crosses U$10 million in annual revenue).

The key is looking beyond the persistent market assumption that startups who fail to raise a next round are destined to fail. Many Series A companies have unique technology, a strong customer base, and can demonstrate product market fit. While they can’t show the exponential growth prioritize by VCs, they can show market traction.

When structured properly early-stage private equity-type deals benefit everyone involved. Founders get a second chance to build their company and find a meaningful exit, VCs don’t have to manage the “walking dead” in their portfolio, and a new private market asset class is created.

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