In 2021 over $621 billion went to start-ups, and there were 959 “unicorns” – companies valued at more than $1 billion – around the globe with an average of 2 new unicorns joining the herd daily. Yet we are starting to see some white caps forming on these frothy valuations, indicating that waves are going to crest and come down as valuations are softening and listings are pulled. We are in for an adjustment.
We believe formation funds and venture studios are well poised to weather market cycles for multiple reasons:
Mitigated downside risk:
Venture studios and formation funds create companies internally from idea. They are investing at inception when the company has zero valuation. Any valuation above that in an up or down market is accretive. In down markets, therefore, even a flat round or a down round (that is not a pay-to-play) will still hold the gains from the initial studio investment.
As founders of these new companies, they tend to have more control over pricing and the terms of future rounds. While this is not always the case, most studios tend to be the largest owners in the companies they create outside of the founders they recruit to lead. Therefore, they are better positioned to select follow-on investors based on favorable terms and valuations.
Flight to quality:
Startups in their later stages must weather a down market through balance sheet cash and expense reduction while continuing to meet their targets. For startups who run out of cash, the situation can be dire, and this is where we see down rounds and “wash-outs.” In these cases, the entire cap table can get reconstructed, and investors who are not participating in the round get converted to common, and typically a meaningless amount of common.
Market contractions create a flight-to-quality for participating capital, where the best companies can survive and even thrive with new rounds of funding. The studio development process utilizes rigorous stress testing at the beginning of development, which ensures only the best ideas get turned into companies.
In down markets, all capital is vulnerable; however, studios tend to be more insulated due to investing at inception, influence in downstream rounds, and developing higher quality portfolios. They are not as exposed to outsized later stage valuations and are able to realize gains from $0.