Is Stripe’s down round a harbinger of things to come?

Stripe, an investor-favorite startup, completed a funding round in March that cut its valuation significantly, slashing it from $95B in March 2021 to just $50B. And this is a platform with solid fundamentals, riding a secular wave, that has announced it is on track to turn a profit this year. 

It is important to point out that the company was not in true fiscal distress, but instead was seeking funds to cover taxes accrued in the process of offering stock grants and providing liquidity to employees. Nevertheless, many investors are rightly wondering whether this “down round” is a sign of things to come for VC-backed companies reaching the end of their liquidity runway.

As late-stage companies transition to fundraising in this environment, we expect more price adjustments like Stripe’s. Of course, this presents risks for investors in VC funds with existing exposure. At the same time, it broadens the range of attractive deal options for managers with capital to deploy - presenting real opportunities for investors ready to put cash to work now.

Waiting out a brutal exit environment

IPOs have practically ground to a halt this year amid a brutal exit environment for late-stage companies. The Renaissance IPO ETF, which invests in a basket of US-listed newly public stocks and is therefore a proxy for the strength of the IPO market, is trading below $30 having peaked at $76 in February 2021.¹

A closer look at sector data, however, suggests that the extent of price corrections will be far from uniform, and is likely to be felt most acutely in the late-stage space. The late stage is the segment of the VC market that is most directly affected by public equity valuation changes for two reasons:

1. There is greater overlap between their investor pools

2. IPOs are the main exit route for late-stage firms and it is easier to create public market benchmarks for more mature private companies

IPO activity is therefore a useful gauge of the relative value (and likely price trajectory) of private companies in the late-stage space (see chart below).

Pricing power shift greater in late-stage VC

As we have written before, slowing private deal activity is putting pricing power in investors’ hands. The chart below shows the estimated capital needs of early- and late-stage venture-backed companies versus what they have received as of Q1 2023. Put simply, the bigger the gap is between what is needed and what has been received, the greater the downward pressure on valuations will ultimately become. Both stages are facing imbalances, but that imbalance is far greater for late-stage companies (see chart below).

The slowdown in activity has been less pronounced for early-stage VC funds for a couple of key reasons: 

1. Valuations got far more frothy for late-stage firms during the IPO bubble in 2021

2. Entry multiples matter less for early-stage VC deals, where the multiple expansion of winning bets is much greater than in late-stage deals

3. There is a lot of exciting new innovation emerging across a range of industries at the earliest stages

As you can see in the charts below, early-stage companies captured a larger share of both deal and fundraising activity in the first quarter of this year than during the VC price bubble in 2021.

This dynamic - with a more dramatic swing in late-stage fund activity - is not unexpected. Late-stage venture returns are more sensitive to movement in the public markets than early–stage returns (see chart below). Returns from late-stage funds that started investing in years when public tech valuations were rising relative to the broader market have been significantly lower than when these valuations were falling. The variance for early-stage fund returns has been far less dramatic. Importantly, both have been stronger during periods of relative tech valuation decline, highlighting the opportunity that recent price corrections may present.

How long can late-stage companies avoid a down round?

It seems that the correction in tech valuations in the public sector has yet to fully flow through to the late-stage space, largely due to muted deal activity.

However, there are many late-stage companies today that are not (yet) profitable and depend on external injections of capital to sustain their growth. This means that they have a finite runway of capital and will ultimately be forced back to the negotiating table for future rounds. The typical amount of runway supplied in each funding round, as well as the interval between them, varies depending on economic and funding conditions and how the businesses perform relative to projections. As a result, precise estimates of when late-stage companies will return to the well are very difficult. 

Startups have historically needed to fundraise every one to two years depending on market conditions. That capital is often projected to last for up to three years, but companies generally try to avoid brinkmanship by seeking new funding in advance of that - often with nine to 12 months remaining.

The current valuation environment encourages companies to stretch their current capital as far as possible. But with many still running on cash raised in 2020 and 2021, when economic conditions were much better (and cash flow projections/needs were likely on the more optimistic side), we expect to see a growing number of companies forced back to the negotiating table later this year and into 2024. It is important to note that this is unlikely to be a flood, more a steady flow, given the staggered way that funds were raised. In addition, the current challenges are likely to create a VC environment marked by greater financial prudence and increased pressure on companies to find a solid product-market fit faster.

Correction a double-edged sword for investors

As we mentioned above, opportunities are likely to emerge gradually, rather than all at once, over the next year. It is nevertheless an exciting time to think about building a VC program, though the lack of an obvious market bottom makes attempting to precisely time any shift a dangerous and probably futile game. 

As such, we recommend making steady allocations to funds over the coming quarters that have an edge in accessing and capitalizing on these emerging opportunities, and trusting managers with experience deploying in tough markets to take their time in putting capital to work in only the best opportunities.

To start a conversation about how we can help you access coveted VC funds with advantageous positioning in this market environment, shoot us an email at advisory-services@optoinvest.com.