When Angela Lee considers the dampened deal flow in the venture capital market this year, she regards it as a necessary retrenching rather than a cause for concern.
“This correction has been welcomed by every investor that I know,” says Lee, professor of professional practice in the Finance Division at CBS.
Lee is relieved to see the frenzied pace of deals slowing down, permitting time for a more thoughtful review of companies’ numbers, management teams, underlying business models, and future prospects. In recent years, she saw founders calling the shots, often asking venture capital firms to complete their due diligence in a matter of days rather than a more typical three- to six-week review.
“Due diligence is not meant to be a punishing exercise,” says Lee, who also serves as faculty director of the Eugene M. Lang Entrepreneurship Center and is the founder of 37 Angels, an investing network that typically evaluates 2,000 company pitches a year. “It’s meant to be an exercise where everybody is learning together what the potential flaws in this company are and how the VCs can help.”
Gauging the VC Market
Compared to 2021, deal flow is down by one-third to one-half this year in both early- and late-stage startups. At the same time, valuations have dropped both in the IPO market and in mergers and acquisitions. In the software-as-a-service industry, commonly regarded as the IPO market bellwether, multiples have fallen from a high of 25x in 2021 to closer to 5x, Lee says.
Later-stage companies have been further affected by the cratering of the IPO market in 2022, which has diminished prospects for a lucrative exit. “The exit market is so important because when companies don’t exit, money is not returned to limited partners, and then limited partners can’t deploy that into the next fund,” Lee says. “So, unfortunately, for early-stage startups, I believe the worst is yet to come.”
In addition to watching the exit markets and exit multiples, Lee is tracking consumer and corporate spending patterns for a good indication of which sectors could perform well in the future.
“At the end of the day, we’re talking about the flow of capital,” Lee says. “As an investor, you need to be asking yourself, what are the areas where spending is picking up? And as a founder, you want to be selling into areas where people and companies have the capacity to pay for your product.”
Navigating the New VC Landscape
Given the new dynamics of the current market and the increased scrutiny founders may encounter when seeking venture capital funding, Lee recommends founders scrub their pitches and prepare for deeper analysis during the due diligence process with VCs.
Too often, Lee sees founders raising only enough funding for their best-case scenario. “In this economy, you might want to raise a little more,” she says. “In your planning, you might want to think through three different scenarios and how you’d respond to each one.”
Founders should always be ready to show why they’re the right team to solve a problem, both in understanding its complexity and in understanding their customers. In an uncertain economic climate, Lee also wants founders to flag their experience. “I like to see founders who’ve been through battle,” she says. “They might say, ‘Look, I lived through a downturn,’ or ‘I know what’s it’s like to sell into a depressed market.’”
While revenue is always a key metric, Lee now encourages founders to dig further into the quality of the revenue. Is it sustainable? Is it cyclical? Does it rely too much on one customer? How long does it take to acquire a new customer? “Is there a viable business model here that works or are we building a company that even when you have $1 billion in revenue is still going to be unprofitable?” she says.
Lee also encourages founders to fully understand their team’s dynamics and potentially eliminate risks before pitching to VCs. She recalls meeting the charismatic founder of a promising company. The first pitch went well but soured when the VCs met the other senior members at the firm. “He was a great storyteller, and everything seemed great,” she says. “But with his team, we watched as the founder wouldn’t let them talk.”
With increased scrutiny of pitches, it’s important to ferret out any leadership risks ahead of time. Lee recommends founders try an exercise she assigns to the students in her leadership class at CBS. She tasks them with asking 20 people who know them well to use three adjectives to describe them, with a caveat that one of the adjectives must not be positive. If there are multiple comments such as “condescending” or “curt,” you then know where to reflect and potentially make changes.
“We’re all getting back to the fundamentals more, so investors and founders are thinking a lot more about revenue quality, profitability, and cash management,” Lee says. “That’s a good thing, since it’s not all hype and dreams.”
Ultimately, Lee believes the more rigorous environment benefits founders as much as VCs. “As an investor, the worst thing that happens to me is I lose my investment. But as a founder, you’ve maybe thrown away four years of your life on an idea somebody should have said no to earlier.”
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