2021 was a year of astronomical growth and, simultaneously, the beginning of a tragic downfall for many startups. That year saw some of the largest funding rounds and highest valuations in history in the VC world, with Discord raising $500M, Databricks raising $1.6B, and Gorillas raising $1.3B.

To illustrate this point, we looked at data published by Crunchbase about the state of the market, funding rounds, and valuations. Crunchbase analysed in this article the “U.S. funding from Series A through Series C between 2018 and the first half of 2022 to look at average and median check sizes to see how they have changed.”

Despite valuations not falling in the first half of 2022, according to Crunchbase data, why do VCs feel like:

Kirby Winfield, Founding General Partner, Ascend VC: “Gotta be like 80% no longer worth $1 billion if you’re using public market comps. I think maybe 5%-10% will fail in 2023, but maybe 40% by 2025.”

Ba Minuzzi, Founder and General Partner, UMANA House of Funds: “We kicked off 2022 with five portfolio companies that had ‘unicorn status’ and two of those have already lost that status. I believe this data is indicative of the overall theme — that two out of every five unicorns will lose, or have lost, their $1 billion valuation. I do see this trend continuing in 2023.”

We are also observing headlines such as this one. In October 2021, Gorillas raised a $1 BN, but less than a year later, TechCrunch posted another article about Gorillas planning to lay off 300 employees and struggling to stay afloat due to lack of funding. Gorillas shared that the reason why they are laying off 300 people is that “it seeks to shift from “hyper growth” (burning tons of cash to win new customers and expand its operations) to “a clear path to profitability.”

So, what happened and how can a company that has raised $1 BN be near bankruptcy 8 months later? And why, despite all-time high funding rounds, do startups such as Gorillas seem to struggle with cash? Gorillas was eventually acquired by its competitor Getir at a valuation of $1B, a nightmare scenario for VCs.

What are Valuations?

To understand what is happening in markets with funding rounds and valuations, we need to go back a few steps and understand what a valuation is. How do VCs and founders decide what a startup is worth and, most importantly, how much it is worth?

We reached out to Joe Kinvi, who specialises in the FinTech industry and is currently working at Paystack in Financial Partnerships, a Community Manager at HoaQ, and an angel investor. Previously, he used to be the Head of Finance at Touchtech Payments, which was acquired by Stripe and later joined Stripe to work in Growth.

Joe shared with us why valuations matter:

“Valuations dictate the potential return for an investor. 

This means that the lower the valuation when you invest, the higher the upside when you exit. For example, when you invest $10K in a company at 1M and the company exits at $10M, then your return is $100K. However, if you invested the same amount at a $500K valuation, then your return would be $200K.” Please note that Joe is using a simplified example and he is not considering the impact of complex investment ideas such as dilution or deal structures.

Joe continues: “The importance also matters depending on the stage of the company. Valuations can be broken down into art and science.

Valuing startups at a pre-seed stage is an art. Art is subjective and appreciated depending on who’s looking at it. Pre-seed and seed valuations are often the same.

Valuing a startup during a Series A and upwards is a science. Science is 1+1=2. Investors are able to use numbers and other relevant benchmark and market data to arrive at a pretty accurate valuation of a company. For example, a company making X amount in ARR, with Y multiple in their industry should be valued at Z.”

How did this happen?

“The market is resetting again from its early 2022 highs but this height was mostly driven by a lot of capital chasing many little deals. At the growth stage, you have founders with lots of term sheets, meaning that they can inflate their valuation and give the deal to the highest bidder. 

It’s simple economics: the higher the demand, the higher the price when supply is limited. Valuations are readjusting because investors have more options to generate a return on their capital (fed increasing the interest rates to cool inflation) and many are quickly realizing that many companies will never grow into the valuations that they raised at. We’ve seen instances where some companies are worth less than what they raised and this has been a cause for concern (Bird is a great example and we will be discussing Bird in the next section of this article). While there is still lots of dry powder (some are calling it damp powder), investors are more cautious and are reverting to valuations fundamentals, after ignoring them for a couple of years. 

Valuations will continue to decrease at the growth stage (post series A) while we see more growth investors move downstream to Series A and the seed stage. This is going to put more pressure on seed stage investors but could be good for angels who invested at a friends and family round or pre-seed stage. We haven’t seen much movement in pre-seed and seed-stage valuations due to the art vs science dilemma. With growth investors moving downstream, valuations at pre-seed and seed can quickly become inflated, making it more challenging for existing angel investors to follow up on their existing investments. If there are liquidity options for these investors, they can earn a decent multiple on their money and recycle that capital into other early-stage deals.”

So what can we expect?

Many startups, such as Gorilla and Bird, are suffering due to changing market dynamics. Bird, an e-scooter company, is facing potential bankruptcy, according to the Financial Times. Venture capital investors have poured more than $4bn into loss-making e-scooter rental companies over the past five years, creating a bubble that is now bursting.

The Financial Times reports: 

“E-scooter rental pioneer Bird has warned it faces possible bankruptcy within the next 12 months unless it can raise more cash, in a sign of a dramatic change in fortunes for one of the hottest tech sectors of recent years. Bird became the fastest start-up to reach a $1bn “unicorn” valuation in 2018, but is now fighting for survival after warning investors it had overstated its historical revenues by tens of millions of dollars.

Venture capital investors have poured more than $4bn into lossmaking e-scooter rental companies over the past five years, according to investment tracker Dealroom.co, fuelled by low interest rates and a wave of hype that small electric vehicles would reshape urban transportation.”

As mentioned Gorillas and Bird is going to be one of many startups that will be facing similar fates. 

Future market trends for valuations?

The glory days are over.

The FT reported European tech groups lose $400bn in value following funding crunch. No more peak valuations as VCs have been reporting write downs to their LPs across their portfolio. As a result many startups have been raising downrounds, bridge rounds or sadly closing down.

As valuations reset, deals will become less competitive, giving GPs more time for due diligence and getting to know the founders. In all honesty, after cases such as FTX along with falling valuations, LPs will be putting pressure on GPs for results. Additionally, we can expect to see more bridging rounds for startups, so they can avoid running out of cash and make it to the next round. This will help them achieve sustainable growth and avoid bankruptcy. Don’t be surprised to see startups raising enough cash to survive for the next 24 months + to avoid fundraising in this unfavourable climate.

GPs will also be forced to be more selective in their investments, as well as more strategic in their approach. Companies will need to make sure they have a sound business plan and the right capital structure to survive the changing macro environment. Moreover, entrepreneurs should be aware of the need to be flexible and adjust their growth strategies accordingly to remain competitive. 

What does success look like for an angel investor?

Is it investing in a unicorn like Uber? Or maybe investing in entrepreneurs from your community. Is it directing more funding to female founders? or maybe successfully raising a VC fund off the back of your track record?

To be honest any of the above could be true for you. It all comes down to your motivations.

Let’s take a look at what Harry Stebbings, General Partner at 20VC thinks

Andy Ayim, founder of The Angel Investing School replied:

In Harry’s post, we can see as a Venture Capitalist his motivation is about making a return from his portfolio of startups. So his advice to angels is really motivated by his VC experience. 

However, Andy rightly pointed out that Harry’s post represents just one motive, which may or may not be yours.

Angel investing is personal finance. Big emphasis on the word personal. Your personal motivations drive what success looks like for you. 

Nevertheless, despite the many different motivations and visions of success, all angel investors are vulnerable to making the same mistakes.

Throughout this article, we will walkthrough the 3 biggest mistakes. 

One of the biggest mistakes we see beginner angel investors make time and time again at the Angel Investing School is the misallocation of capital. New angels are often so passionate and keen to invest in their first startup that they forgo some of the most crucial fundamentals of investing.

We see lots of excited angels who set off on their journey and either invest their money too quickly, invest money they don’t have or have no money to follow on their successful startups. 

Do not panic though. Capital allocation is the most challenging aspect of angel investing and we want you to get it right! Below are the 3 most common mistakes angel investors face when allocating their capital and how to avoid them.

1) You invest your money too quickly 

Becoming an angel investor is a very exciting time. There are so many different types of founders, startups and ideas in industries you have probably not even thought about. It is easy to fall into the trap of wanting to invest in every founder who shares with your their revolutionising startup idea. We get it! Staying rational and disciplined is the hardest thing for a beginner angel investor. However, what happens if you spend all your money at the beginning of your angel investing journey there won’t be any left. 

Imagine you saved up £30,000 of your hard earned cash and started angel investing, you meet an inspiring founder that leaves you excited, curious and with a fear you will miss out if you don’t move quick. You decide to invest £15,000 (half your saved pot for investing) because you REALLY believe this will be the next big thing.

This is a rookie mistake, but a common one that is so easy to make. We don’t want that to happen to you!

How to avoid this mistake:

This is probably the hardest mistake to avoid but it’s important to be disciplined with your capital. Take your time before writing your first check. Join a few due diligence calls to get a feel for some of the key questions that more experienced angels ask before making a decision to invest. Speak to a variety of founders to get a feel for the types of different founders that exist. Speak to a variety of angels to understand their perspectives and learn from how they think and make decisions.

As you get more experience you will naturally become more disciplined with your money so do not rush your angel investing journey. We also recommend, do not set yourself targets when you want to invest. You will know when the time is right. Most importantly don’t force it and don’t let FOMO (fear of missing out) dictate your investment strategy. This rarely ends well for investors. 

You will miss out on great deals, but don’t forget every year is filled with new opportunities to invest.

2) You invest money that you don’t have

Another golden rule we remind our community members at AIS is never to invest money they don’t have. What we mean by that is that don’t invest your life savings into a startup that you think is going to give you a 100x return and a few months later that startup goes bust. Thinking back to the statistics on how likely a start-up is to succeed (1 in 10), as an angel investor, you should never invest money that you don’t have. Even if the startup you invested in is successful, remember that your investment is going to be tied up for years and you are unlikely to see your money in the near future.

How to avoid this mistake:

Make sure that all your bills, necessary expenses such as your mortgage or rent, bills and living costs are paid for before spending any surplus money on your angel investments. Only invest from your disposable income. For example, you saved some money to buy a nice expensive jacket? Instead of buying this jacket, consider using this money to invest in these amazing founders that you have just met. They have determination, strong product-market fit and operate in a growing market (always do your due diligence!). That sounds like a great trade-off! The key to remember is, NEVER invest money that you cannot afford to lose. We want angel investing to be a source of joy for you and not stress.

3) You have no money to follow on your successful investments

There are a number of strategies that you can implement as an angel investor when it comes to structuring your investment portfolio. There is the “spray and pray” strategy for example, where you invest capital in as many startups as possible and hope that a few will succeed. However, a more common strategy that is seen amongst angel investors is diversification and saving some money as a follow-on to avoid being diluted down the line by larger investors such as Venture Capitalists and Private Equity houses. This is because follow-on investment is necessary to avoid having your shares diluted and long-term returns eroded. This is why avoiding mistake #1 is key because if you spend all your money at the beginning of your angel investing journey, you have no money as a follow-on to your successful investments. 

How to avoid this mistake:

Avoid spending all your angel investing money at once. Make sure you keep some money aside to invest in your successful startups when they are raising again. Having follow-on capital is important because it allows you to maintain your equity stake, not get diluted and hopefully eventually make some healthy returns. As a rule of thumb, use the 50/50 rule. 50% of your angel investing pot will go to initial angel investments and 50% will go to your follow-on investments.

Jason Calacanis was able to turn $100,000 into $100 million through angel investing. If he did it, why can’t you right? wrong.

Remember, angel investing is a risky business, so even if you avoid the 3 most common mistakes we listed above, it doesn’t guarantee you will make a return. This is why we put so much emphasis on having the right motivations upfront in order to manage your expectations. Making a return is your best case scenario, but please don’t forget what the worst case could be. Get comfortable with taking the risk and investing if the worst case scenario plays out. Just make sure that the worst case doesn’t involve you allocating too much capital, investing what you can’t afford to lose or not saving enough capital to follow on with your winners.

I hope this article helped you to rethink your capital allocation strategy and you have learnt a thing or 2! Interested in learning more about effective capital allocation for angel investors? 

Check out our community, programs and membership here. Most importantly if you join our community, you will never be alone on your angel investing journey.