Angels should mind the VC dip but need not fear it

While this might be a difficult time to sell, it might also be a very good time to buy into certain startups. Who doesn’t like a sale?

Global startup investing in mid-2022 is starting to track the downturn in the public markets, just as it did in past dips and after the usual one-to-two quarter time lag. While angel investors should always be cautious and understand what this means for their existing startup portfolio, they should also be engaged by the opportunities that this correction brings.

Many public tech stocks have dropped 50% or more, with some already 70 or 80% off their highs. While this can be nerve wracking for those holding these stocks, it means that many of these companies are essentially on sale, creating an opportunity for selective investors to participate in deals that just a year ago might have cost much, much more.

“Cheaper stocks are a good thing for those investing now, and they’ve become a lot cheaper in a very short time,” James Mackintosh observes in the Wall St. Journal.

While not yet as pronounced, the startup market is following this clear trend and valuations are falling. 

“Forward revenue multiples – the primary valuation methodology for public SaaS companies - have fallen on average by 67% from their 12-month highs and for some companies by almost 90%,” Alex Clayton, a technology investor at Meritech Capital observed in May.

The trend has continued, with public SaaS company valuation multiples falling from double digits to around 6.5 times earnings, says Zak Schwarzman, a general partner at MetaProp VC – a level not seen since 2016. In this climate, private software companies will have a hard time justifying why their own valuations should not also be re-assessed.

While this might be a difficult time to sell, it might also be a very good time to buy into certain startups. We know from previous downturns that companies that succeed in managing the dip with robust business plans and minimum burn rates, emerge strengthened to succeed in the future. We are seeing serious family offices, institutions and other sophisticated investors scouting out these cut-price investment opportunities. Who doesn’t like a sale?

What are some of the signs to look for? Any company that is continuing to grow its revenues and improve its margins despite the rocky financial environment. Companies whose valuation reflects newly adjusted industry multiples and follow the trendline of public company comparables. Companies that have a long runway so they can survive at least two years in this uncertain environment. And, ultimately, companies which have a clear path to breakeven and profitability where the unit economics are solid.

“In order to maintain strong multiples, private companies will need to demonstrate strong revenue growth, as it is a major determinant of the multiple received in the public markets,” according to Silicon Valley Bank’s State of SaaS report.

Despite the recent fall in venture investment compared to the eye-watering numbers we saw in 2021, the fundamentals and future promise of robust technology startups remain the same.

Total startup funding worldwide in Q2 2022 was $108.5 billion, a 23% decline from Q1, “the largest quarterly percentage drop in funding in nearly a decade,” according to the CB Insights State of Venture Global Report, Q2 2022.

But context is everything. 2021 was a staggering, record-breaking year for venture investing. As CB Insights notes of the quarter just ended: “While the new funding level marked a 6-quarter low, it was still the sixth-largest quarter for funding on record.”

Tracking global trends, Israeli startups raised $4.1 billion in Q2, also the sixth-best quarter on record, but a 27% decline from Q1, according to the IVC-LeumiTech Israeli Tech Review, Q2 2022. “Almost all the components of the Israeli tech investment arena indicate that a sharp downtrend is underway,” the IVC notes.

It all depends how you measure a “downtrend,” and from when. In 2020, Israeli startups raised $10 billion, an increase of more than 25% over the previous year and a record at the time. In the first half of 2022, Israeli startups raised $9.4 billion – almost as much as the whole of 2020.

Israeli tech investment in 2021 capped $25 billion – more than double 2020 – fueled by post-pandemic growth, near-zero interest rates and a pent-up demand for opportunities from tech investors whose wealth had risen dramatically during the Covid crisis. It was inconceivable that venture investing would continue to experience year-on-year hypergrowth of 100% or more in perpetuity.

100 unicorns

Israel now has 10,000 startups – the highest per capita concentration in the world – and almost 100 of the world’s billion-dollar unicorns, almost 10% of the global total. Israel has under 10 million residents, a little more than 0.1% of the world’s population. Statistically, Israel should have produced only one unicorn, not 100. In H1 2022, Israel minted 27 new unicorns, second only to the US with 134, according to a new report from Viola, Israel’s High-Tech Ecosystem in Times of Market Volatility.

Despite its tiny population, Israel remains in absolute terms the fifth-largest venture investment ecosystem in the world, behind the US, China, UK and India.

Key sectors of Israel’s startup economy are flourishing due to the country’s specialist expertise in a broad range of vital or emerging industries including cybersecurity, MedTech, AgriTech, quantum and mobility.

In addition, Israel’s official inflation rate is running at only 4.1%, much lower than the US, UK and other developed economies.

Investor strength

But when Wall Street catches a cold, Rothschild Boulevard sneezes. Much of the investment in Israeli high tech comes from the US, so it may not be surprising when American investors reduce the velocity of their massive investments in Israel and other distant markets.

As the Viola report notes, the main slowdown in Israel in H1 2022 was in mega investment rounds of $100 million or more, which fell by 35% from the same period in 2021. But growth-stage funding fell only 10%, from $3.5 billion in H1 2021 to $3.2 billion in H1 2022, while the amount invested in early-stage deals fell from $3.4 billion to $2.9 billion in the same period while  the number of individual early-stage deals rose from 606 to near 700, suggesting an adjustment for lower valuations.

Based on simple observation of the impressive flow of delegations and visitors to Israel from Europe, Asia, Latin America and Oceania, they seem ready to fill any gap that may result from a US investor pullback. We are seeing continued investor strength from those regions.

We also need to remember than even though the US leads the world in venture, it is not the whole world. “While deal volume is down more than 30% in Q2 in the US, that’s not the case in EMEA,” Eze Vidra notes in his Venture Capital Café, essential reading for anyone interested in clear-eyed analysis of VC trends. “European startups raised record amounts in Q2 2022, with June being particularly active.”

In addition, Vidra notes that the amount of “dry powder” – capital looking for investment – is at record levels. Investors are still looking for returns higher than they can expect from banks or bonds. With continued pressure on the public markets and the decline of SPACs, we can expect that smart capital will continue to find its way into venture deals.

“Diamonds are formed under pressure,” Vidra reminds us.

About ‘Investors on the Frontlines’

I’m the CEO and Founder of OurCrowd, the global equity investment platform that gives individual accredited investors access to pre-IPO startup deals alongside top-tier VCs. If you are an investor, private family office or financial advisor, subscribe here for my biweekly commentary or follow me on Twitter. I welcome your comments in the response section below.