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.