We've gotten questions from some of our founders about what is happening in the broader market (recession?) and what the prospects are for fundraising in this environment. In short, fundraising has become more challenging and is likely to remain so for some time.
While we don't have a definitive answer on how to navigate this, we think it's important for all the EdTech founders to understand the reality of the present situation, explaining why we created this short generic guide.
Note: This is a distillation of recent market observations. The info is based on the sources cited herein, chats with portfolio cos and other funds & Brighteye team members beliefs. It is in no way meant as investment advice and should not be taken as such.
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I) Current macro situation / public markets
📝 Tl;dr While the long term opportunities inherent in technology remain strong, in 2022-23 interest rates will be higher, economic growth slower, capital more expensive and public equity valuation multiples lower than was true in recent years, and there is potential for longer-term headwinds if macro conditions deteriorate further.
Inflation has hit 30+ year highs across the US (8.3%), UK(9%) and Europe (7.5%). At the onset of the pandemic, many governments lowered interest rates and raised spending and liquidity, creating an increase in spending power, i.e. more demand. At the same time, pandemic related disruptions meant that labor, goods and services were less available, i.e. less supply. Increased demand combined with decreased supply meant prices began rising across the board beginning ~18 months ago. As supply disruptions have continued, exacerbated by the war in Ukraine, lockdowns in China, Brexit, etc, prices have continued to rise.
Central banks are raising interest rates in response. The US Federal Reserve (central bank) has already begun raising interest rates (anticipated to reach 2-3%) as has the Bank of England and European central banks are expected to follow suit (details here). Raising interest rates is meant to bring prices down, but will also slow economic growth, even as governments scale back spending, further slowing economic activity.
Higher interest rates decreased valuations of public stocks, particularly high growth stocks. As of May 12, the US S&P 500 was down 18% from all time high reached in early January, while median public company software valuations have dropped from 12x forward revenue to 5x or less since highs in October 2021. Public stocks are typically valued by discounting anticipated future cash flows. Discount rates are indexed to interest rates so raising interest rates increases the discount rate and lowers stock valuations. Because high growth companies have a higher proportion of their cash flows in the future, growth stock valuations are more impacted by rate rises.
From here, different macro scenarios are possible, ranging from mild slow down (”soft landing”) to recession to stagflation (Pitchbook breakdown here) generally, the longer inflation stays high, the higher interest rates will go, the more the economy will slow. For what it’s worth, while Pitchbook does not view a US recession as likely (20% chance) they do believe that rates will remain high and therefore valuation multiples will stay low, “We do not see a quick reversal in asset valuations. Private market investors should prepare for valuations to be marked down in the coming quarters, especially in VC.”
II) Private Market & VC impact
📝 Tl;dr Valuation multiples have fallen, strong deals are still getting done but are taking longer and at lower valuation multiples than in 2021, weaker deals are not closing. VC and PE funds have significant dry powder on both sides of the Atlantic, which can help limit fallout and provide paths to liquidity, but they will likely favor profitable companies.
Decrease in public market growth valuations are lowering valuations of privately held companies. Growth stage valuations are falling in private markets in rough proportion to public market adjustments, with later stage companies seeing these effects more immediately. Per Andreesen Horowitz, “You can get a rough estimate for the change in your valuation by looking at leading public companies in your sector. If they’re down 60%, there’s a good chance you’re in a similar position.”
Repricing in the private markets has just started and is slowing the pace of dealmaking Q1 2022 saw relatively little change in deal volume and average valuations in US and Europe, but deals signed in Q1, may well have been priced 3 months earlier. Our own experience is that the rapid change in macro environment has meant that deals are taking longer to get to term sheet, and valuation multiples are ~25% lower than initially anticipated at Series B. We expect that while repricing is happening there will be less overall deal volume as uncertainty on the part of both funders and founders makes it more difficult to come to agreement on terms.
IPO volumes have decreased as has exit volume in Europe, Global IPO proceeds decreased 51% in Q1 and exit proceeds in Europe in Q1 fell significantly as well (€7.7B in Q1 2022 vs. €60B average/quarter in 2021), signaling there may be less liquidity available for founders and funders in coming months. That said, median exit values remained high in Q1 in the US ($90M, 1.5X previous private valuation), suggesting continuing demand for fundamentally strong companies.
VC’s have significant dry powder and funds continue to raise. Global dry powder was $478B at the end of Q1 , with 1/3 of that targeted at early stage. European venture funds had €47B in dry powder as of the end of 2021 and raised another €7.4B in Q1 2022, on pace with last year. Meanwhile US funds had $300B in dry powder as of the end of Q1 2022 and raised $74B in the quarter. Given that over 25% of European VC deals had a US investor in 2021, and an increasing number of US funds established offices in Europe, that’s a significant amount of capital accessible for European founders.
PE dry powder is close to an all time high of $1.8 Trillion as of February, 2022 creating a path to liquidity, particularly for EBITDA positive companies, albeit at lower multiples than strategic acquisition or IPO.
Given amount of dry powder, activity will certainly continue, but there will be much more attention paid to growing efficiently, as opposed to just growth.
III) What does this mean for your fundraising and spending strategies in 2022-23?
📝 Tl;dr If you can grow quickly and efficiently, capital is still available. Otherwise, you should try to give yourself as much flexibility as possible within your runway (24+ months ideally), consider prioritizing profitability over growth as well as exit opportunities.
Know thyself: If you are post-seed, growing quickly in a capital efficient manner, fundraising is realistic albeit likely at a lower multiple than in 2021.
Growing quickly is ~3x+ year over year revenue growth at Series A, 2-2.5x+ at Series B, a bit more unclear what growth rates are acceptable at Series C and beyond (useful benchmarks re: revenue growth in SAAS here), but two of the entities that have been most active in growth (Softbank, Tiger) have publicly slowed down significantly and/or shifted focus to early stage, so there is less capital available.
Capital efficiency is best measured via burn ratio, usually defined as cash burned divided by net ARR added. This is expected to be higher for earlier stage companies and decrease over time, a useful heuristic here from Andreessen Horowitz:
A good overview of what is fundable (for Series A & B SAAS companies) from Craft Ventures
Important Caveat #1: Just because you can raise, doesn’t mean you’ll necessarily be able to raise at a premium to your last round (depending on when that was and what valuation multiple was).
Important Caveat #2: These are heuristics, companies with unique technology, teams, growth, etc that don’t meet these criteria may well continue to raise, particularly at early stage, but they will be few and far between.
What if you’re not fundable per the above criteria? A good heuristic from Tom Tungusz (full post here)
Option 1: If you are not currently fundable but have sufficient momentum to get to profitability on existing runway, even if it means cutting burn and sacrificing some growth, that may be the optimal path given current uncertainty.
Option 2: If you are not fundable and have sufficient runway (12+ months), then you should consider restructuring to provide more runway to give you the time to adequately establish sales efficiency and growth (if that appears possible), and/or establishing partnerships which can provide a route to exit and better product market fit.
Option 3: If you have less than 12 months cash, are not fundable and have no path to profitability, you should evaluate the prospect of an exit or inside round and/or reduce burn to extend runway and give yourself more time to hit funding benchmarks.
What if you’re pre-seed?
Generally seed funds operate on 6-9 year time horizons so are less likely to be affected in terms of deployment pace by the current down turn.
Seed valuations are less based on traction and more based on potential, round size, team, etc.
We do, however, expect the median size of seed rounds to fall a bit in coming quarters.
Also, the expectations at Series A in 18 months are not likely to be too different from what they are today, so understanding what is expected now will help you better gauge key metrics needed for next round of funding and how best to allocate your seed round.
IV) How to think about costs & reducing burn (if necessary)
It is worth asking whether whatever cash you have and/or raise in the next 12 months can get you to breakeven again, even if it means sacrificing some growth there is a lot to be said for controlling your destiny in tougher environments.
If a recession is prolonged, capital may be more difficult to access once current dry powder is spent.
If not, then capital is likely to be more plentiful and you can likely access it to increase momentum if need be.
A more nuanced exercise would be to look at how long it would take you to get to breakeven if you had to, and then back into when you would need to raise in order to avoid slowing down.
Inflation is likely to impact you directly even in a steady state, your costs are likely to increase as employees feel the cost of living increases and will want an adjustment. It likely makes sense to model out scenarios where growth = x% (eg 1.5x, 2x, 2.5x) and costs increase y% (eg 4, 8, 12) what the runway implications of each of these scenarios.
If cutting costs is necessary to extend runway, it’s best done quickly, all at once rather than piecemeal. The classic slide from Sequoia’s RIP Good Times is self explanatory:
Cutting costs need to be thought through systematically, again, from Sequoia:
Engineering - decrease headcount for next version?
Product - what features are absolutely essential?
Marketing - measuring & cutting what’s not working?
Sales/Bus Dev - ROI on expense increase?
Pipeline - Real probabilities of closing deals?
Finance - (i) Where can payments be deferred (ii) What G&A departments are essential?
V) A few positive things about the current situation
Part of our pitch for Brighteye is that education is a recession resistant industry. Economic downturns drive people to seek training and governments to increase spending for training/learning, and booms increase the return on knowledge/expertise. We saw some of this during Covid and expect it to continue if/when the economy slows down.
VCs are still writing checks (even Andreessen and Craft who are among the most vocal about current crisis have continued investing) and, as noted, have a fair amount of dry powder to deploy.
AMAZING companies have been built during difficult times (e.g. Paypal, Uber, Google, etc.)
Less emphasis on “growth at all costs” gives you the ability to build at a more rational pace, which, generally, is more favorable for edtech companies which, in our experience, tend to have more of a focus on balanced growth.
Talent is likely to be a bit easier to access and to hold on to, particularly if you have a path to navigate the current climate. Many people who otherwise may not have been approachable are now potentially within reach.
There will be less noise in your space → less companies getting funded and bragging about it, which essentially translates into less competition and more focus.
A good overview of the upside of down markets from Lightspeed here