The VC/startup aftermath of 2020-21's "sugar high years" with Carta's Peter Walker

Welcome back to Above Board. We’re getting back into the VC and startup data once again this week with Peter Walker, Carta’s Head of Insights. Let’s jump right in.

AB: Welcome back to Above Board, Peter. Thanks for joining us again. What are the conversations boardrooms should be having around fundraising right now and what do you see in terms of issues going on in the boardroom around misnomers of the venture environment right now?

There’s always a question of timeline that comes up frequently. For how long will this money last the company? If I'm reading the tea leaves correctly- a little bit of data analysis and a little bit of educated guesstimating- in 2023, a lot of boards and candidly, a lot of investors in general, were like, “hey entrepreneur, the world changed on you.”

This is where we see bridge round percentages at all-time highs on Carta. VC’s have been willing to give founders a little bit more capital to help their transition from one world to the another- the low interest rates to higher rates, etc. I am getting the sense that in 2024, those bridge round conversations are resolving back to “no more.” VC’s are less willing than they were to underwrite a bridge.

The other is just that the dynamics of this venture market are very different from the up and to the right sort of everyone on the same train that happened in 2020 and 2021.

Sector differences are more apparent now than they were before, with AI obviously being the biggest one. Even into biotech, hard sciences, and hardware- the difference between building in atoms and building in bits have seen their medians pulled apart somewhat.

The last big one is the terms of the deals. This is actually a silver lining. I think it is a misnomer to say that a lot of added structure such as participation for stock, multiple liquidation preferences, etc., has made its way into the early part of the market. It really still hasn't in early stage deals. 

Most of the time, what I think is happening is that those deals are just not being done instead of being done with a lot of structure, which is good and bad, depending on your point of view. But in the later stage part of the market, structure is definitely back on the table in a way that was pretty rare in 2021 in particular.

So maybe the biggest thing to know as a board member and investor is to try to excise the knowledge of 2020 and 2021 from your brain and work back off of your 2019 comps. And maybe things will just be a little bit more reasonable then because the sugar high of those two years has just thrown everything off.

AB: What are the market indicators a board member should be watching to help their company?

PW: In terms of the health of the ecosystem, the most basic, but useful one is IPOs. Are we getting back to health and IPOs? That matters a ton. 

The other is percentage of bridge rounds, which is a good indicator of where VCs are modulating their time between keeping current portfolio companies alive and then betting on net new things. We want to see this number decline back to more historical averages from, I think it was 45 percent of Series A's during the recent boom in bridge rounds. The last quarter on Carta, we saw 25-30% which is a more healthy number. 

The other thing to keep an eye on are bootstrapping and revenue-funded approaches. There's going to be a lot more founders who choose to take opposite or different routes from VC. Board members should be asking themselves if there are boards that they're sitting on where another fundraise isn't actually the right move. I'm sure the board has already had these conversations in many cases, but this move to profitability and rational growth is here to stay in a way that I hope kind of materially impacts the growth projections of these businesses. 

Unless you're Anthropic, it's pretty tough to pursue “growth at all costs” right now.

AB: What should founders know about how the current market environment is affecting their investors?

PW: Two things that founders should know is that in this downturn, the experience of going back to VCs for bridge rounds has become completely normal. In a normal year, a VC would have to choose which portco’s to re-up on a bridge round- that's now happening across a much, much wider percentage of their portfolio. So, if it feels like a VC is not supporting a portco, it's because the VC firm is being asked by all of their companies in many cases.

I have fund managers who have told me every single one of their portcos has asked for a bridge in the last 12 months. That is not the standard in venture. 

The other thing, which is interesting, is that there are people out there who say that VCs are acting “creatively” in order to maintain the valuation marks of their current portfolios so that they can raise their next fund before they have to mark things down. To me, that's a little strange. You would have had to mark things down in many cases already, but we did see a big increase in the percentage of bridges and extensions that are being done on SAFES or convertible notes, which do not carry a valuation question on them.

You don't revalue the company when you raise on a SAFE or a convertible note. So that keeps that valuation wherever it was, and so the VC doesn't have to mark it down when they go out and fundraise from their new LPs. That is a dynamic that I see happening. I don't want to speculate on how widespread it is, but we are seeing convertibles and SAFE used in ways that they hadn't been used really for quite a long time.

AB: Especially for the LPs who read Above Board, what are the takeaways you see from a fund performance perspective across the different firms that use Carta?

PW: I think LPs are evaluating different things at different parts of the stack when it comes to venture. If you are an LP into the newest Andreessen fund, for instance, you are not evaluating that fund on the same basis and you might be using some of the same metrics, but certainly not the same frameworks as you would the emerging manager who's raising a 25 million fund, which again, paints the problem of there were a lot, and I mean a lot, of venture funds that started in 2019, 2020, and 2021. And even 2022. 

Some of those funds began investing into that vintage immediately. And so much of their portfolio is invested at overvalued companies.

AB: There's lots of good people on the hiring market. Yet, you still hear most founders say one of their biggest pain points, if not the biggest one, is still hiring. What does the data say about how we should be thinking about the market environment around hiring and layoffs?

PW: It’s cooled in terms of layoffs, but it’s not cold. It's certainly still quite a warm layoff environment, which is unfortunate to see. In terms of these two contra trends, you're right, they're both happening at the same time.

Companies on Carta hired half as many employees in 2023 as they did in 2022 from 500,000 or so in 2022 to 250,000 in 2023. So, it is a massive drop in terms of just new hires. 

We also see that 50 people are getting laid off for every 1 leaving by choice, which is not a healthy market. Usually you'd want that ratio to be four to one, five to one, six to one. So, there is tons of talent on the market. 

Companies are choosing to hire less frequently, both because of the major shifts in the cost of money but also because they're getting a ton of advice about keeping headcount flat or even reducing to show better metrics on their unit economics.

AB: Is now an opportune time to be deploying capital?

PW: I would say that yes, now is a good time to start deploying. You have to segment it out by industry. There is a hype wave in AI at the moment. I think there are AI valuations and round sizes that feel very 2021’ish and will probably result in a lot of wasted cash. That's just a fact. Of course, there's always a lot of wasted cash in venture, and it's not really wasted because the fund model makes sense. And as long as you get that 100x return on a company, it makes sense. So there's going to be that all the time. But I do think that there's a hype cycle around AI right now that feels very similar to crypto. 

The other thing that is coming up that I'm very curious about is the “middle part” of VC. If founders truly internalize the message about capital efficiency and if (and these are two big if’s) AI tooling allows you to build a business that achieves much higher ARR employee than you could in prior days, it begs a question: do you need those $50-100 million rounds. Or will you as a venture-backed business do your seed round, maybe do a series A, and then stop fundraising?

I think a lot more companies than before are going to try it. I don't really have a good perspective as to whether or not they are going to succeed.

But if they do succeed, that has big implications for late stage funds. Where is that money going to go? Some of it is going to try to go early stage, but then that impacts the valuations and supply and demand economics of early stage VC. Perhaps we're in this period of transition where venture capital might look materially different in three to five years based on the company's capital needs, not just the VC's appetite for those companies.

AB: What do you think is the future of VC?

PW: I would perhaps bet on it that venture is going to be a materially smaller industry in terms of total funds, which is a shame because it is true from our data that emerging managers tend to invest in different kinds of people, giving more people a shot at the venture journey and ecosystem. All those things are good things, but LPs are often making some data driven decisions about the early stage venture funds they invest into and if your only data is negatively impacted by the pandemic shift, then you're in a really tough spot.

AB: Prediction time: when we look back 10 years from now on the vintage you called the “sugar high years” of 2020 and 2021, what is the performance going to be?

PW: On the exit side, I would have to assume that there are going to be fewer, but perhaps not materially so. I think the cream of every venture crop is still high. There are going to be companies that raised their early stage rounds in 2020 and 2021 that ended up being great bets. There are likely just going to be fewer and far between the number there are in a normal venture year.

The difficulty is going to be the destruction of the paper value of a lot of those companies, which has already caused some ripples through the venture ecosystem. The lack of IPOs rippling back through all of venture, I think is underrated into how it impacts net new investment decisions. And by that, I mean that if you are an LP and you are unable to get capital back through DPI, actual realized dollars because your funds are holding on to these investments that should have IPO'd but they can't because they were overvalued at their last round, it really materially impacts your ability to invest into the next fund. 

Again, this comes back to the timescale of venture funds. It may not appear right now, but it's going to have materially negative impacts down the road. I think we are cautiously getting back to healthy, but it's going to take a while.

AB: One final question for the data expert: what role should looking at market data play in a board’s work?

PW: In each individual instance, it is helpful to have benchmarks; ie: you're coming into a board meeting and you want to talk deeply about the current headcount allocation at a portfolio company and how they've over allocated to marketing and G&A and under allocated to R&D.

There are some good benchmarks out there that are fresh basically every year or so to show you what makes sense. It’s important to remember that oftentimes there will be really good reasons why the founders have chosen to deviate from those benchmarks. 

It’s incumbent upon and a useful role for the board member to bring some ideas about the market and their experience, and then to discuss whether or not they apply. But I do think that sometimes it's too simplistic to say why a company is out of whack on a part of a given chart—sometimes that out of whack part may be making the business run as well as it is. 

As a complete data nerd myself, sometimes I have to take a step back and ask myself: what does this actually mean?

Peter, thank you for all of the amazing perspective and data you have shared with the Above Board community. Have a colleague/friend who you think could benefit from this data? Please forward this newsletter to them (they can sign up for Above Board here).