It’s 2022. Two years into our ‘new normal’ and another wave of economic uncertainty has hit. This time it’s a looming recession, which has triggered reactions across financial markets to batten down the hatches to prepare for a massive decrease in investment activity.
Major investors such as YCombinator (YC) and Sequoia Capital have shared their words of warning to their portfolios with the public. YC commented on what could be a moment of opportunity for brave and savvy leaders: "...economic downturns often become huge opportunities for the founders who quickly change their mindset, plan, and make sure their company survives."
This “survival of the fittest” approach to supporting portfolio companies and trimming excess spend has also led to the impression that investors are now sitting on mountains of dry powder, ready to deploy at a moment’s notice. The reality? According to VCs on the ground, it’s a narrative that’s been overblown.
The three largest changes are in startup spending, where VCs are spending money (not whether or not they are), and why they’ve changed their strategy. Let’s explore how these stories have created a new narrative.
Decreasing valuations and a thinning unicorn herd
The U.S. saw monthly funding drop by 37% through the end of May. In comparison, funding declined in Europe by 50% over the same period. This drop is being acutely felt by portfolio companies. They’re weathering the storm and focusing on tightening operations while also fighting to reach profitability over a “growth-at-all-costs” mindset and meet their companies’ missions.
As valuations, especially in tech, shrink (early-stage valuations have declined quarter-over-quarter for the first time in 10 quarters), this caution is sensible for both smaller private companies and larger industry giants that are also rapidly losing inflated valuations. But if venture capitalists are still holding significant amounts of dry powder, where are their dollars going?
A tighter criteria for deals doesn’t mean deals aren’t closing
A shakier global economy makes any investment a riskier endeavor, and investment firms are responding by tightening their criteria for deals. There has been an increased focus on due diligence and on evaluating factors like burn rate, Total Addressable Market (TAM), and the experience of a team’s leadership as criteria for making better investment decisions.
Affinity’s 2022 U.S. vs. European Relationship Intelligence Benchmark Report shows that deal count has decreased in both regions—U.S. VC pipelines saw an 8% decrease in new opportunities from Q1 2022 to Q2 2022; in Europe, VCs saw a 31% decrease in the same period (though this comes after a whopping 23% rise in 2021 through Q1 2022).
While the numbers show that deal count slowed in response to the greater economic e-brake, our report also found that VCs are actually increasing their outreach. U.S. firms saw a 10% growth in meeting activity and emails sent in the first half of this year, and European firms saw a 9% increase in meetings and a 3% increase in emails sent during the same period.
Additionally, U.S. VCs prioritized building the right relationships in Q1 2022, expanding their business networks by a staggering 39% compared to Q1 2021. European firms committed equal attention in the first quarter of the year with a 22% growth in business networks compared to Q4 2021.
If deals are slowing but outreach and networking activity continue to increase, it doesn’t mean VCs are slowing down or necessarily spending less. The trend points to a shift in priorities: They’re looking for the best opportunities to invest in or they’re pursuing other avenues—such as “up rounds in name only” and venture debt.
A race to the top with wider steps
The increase in outreach and networking activity shows that VCs are still set on finding deals and companies to invest in. But they’re not in a race to the bottom to find startups in desperate need of cash.
Investment dollars aren’t flowing freely or being held tightly, waiting to be invested. Instead, firms are competing to invest in a smaller pool of companies that meet a tighter investment criteria. They’re honing their investment theses, investing in their tech stack to gather better data and identify deal signals sooner, and patiently wading through more thorough diligence stages before committing to a deal. All the while, they’re trying to meet these new operational standards before their competitors and find the next unicorn hidden in a herd of horses.
The trendline is down, but the VCs aren’t out
The massive explosion of deal activity in 2021 set a monumental (and unsustainable) high bar for success. Now, firms are experiencing a double downswing—the combined result of a return to normalcy and a global economic downturn.
But great companies have emerged from recessions before, and VCs are diligently keeping their eyes on the prize. Their investment dollars will be spent conservatively and intentionally through a more focused, more data-driven decision-making process.