The Crash in Venture Capital Investment Following the Tech Boom

by Elena Cavallaro, Roxane Kohler, and Vittorio Filippini

Introduction

When pandemic-induced lockdowns started in March 2020, partners at some Venture Capital (VC) firms became increasingly concerned about an overdue correction. Instead, the opposite happened, and the pandemic pushed the market into one of the strongest bull periods on record. The flood of money into the private markets was matched by a comparable surge of IPOs. According to Coatue, one of a new band of “crossover” investors that moved from the public markets into the VC sector, $1.4tn found its way into promising growth companies globally last year, half of it in the form of VC and half through IPOs. Now, amid a geopolitical crisis and a downward-trending stock market, some in the industry say the overheated venture capital climate is finally beginning to cool down.

Case Study

Sequoia Capital is an American VC firm founded in 1972 in California, when the term “Silicon Valley” was just 2 years old. It is known for backing companies that now represent $1.4tn of the total combined value of the stock market as of 2022. Specializing in technology and innovation, the VC was an early investor in many well known tech firms such as Apple, Oracle, Youtube, Instagram, Zoom, Google and more. In fact, Sequoia focuses mainly on seed-, early-, and growth stage technology companies.

Therefore, during the cryptocurrency boom in 2020 and 2021, Sequoia was quick to invest in FTX. FTX was an emerging cryptocurrency exchange founded in 2019 and based in the Bahamas due to its favorable regulatory environment. It soon became the the third largest crypto exchange by volume, peaking at $807m of daily trading volume in September of 2021 and representing a 25x year on year growth from April 2020. Therefore, even compared to other crypto exchanges in the midst of the bull market, FTX was one of the fastest-growing crypto exchanges in the industry, and a target for VCs such as Sequoia. FTX’s success was largely due to it being easier to use than alternatives and catering to an array of diverse audiences. Products such as future contracts like “Trump 2020” which allowed traders to bet on the US election outcome and their unique margin collateral loan wallets that offered a simpler way for traders to manage which wallets they used as collateral, set the company apart from its competition. Founder and CEO Sam Bankman-Fried’s personality also attracted investors, portraying a genius multitasking persona.

Consequently, in July 2021, Sequoia Capital invested $214m into FTX which was valued at $18bn at the time. Attracted to a founder that was seen as a visionary and amid the boom in crypto investments, Sequoia neglected typical corporate controls for investments this size such as external board oversight. Up until earlier this year, this proved to be a good investment as FTX was valued at $32bn at the beginning of 2022. However, things soon took a turn for the worse in November of 2022 when FTX ultimately went bankrupt. On the 2nd of November, Coindesk revealed leaked documents that proved that Almeda Research, the quant trading company also run by Bankman-Fried held a position of $5bn in FTX, a native FTX token. Because the tokens were not fiat currency or another cryptocurrency, this sent concerns through the crypto industry regarding the undisclosed leverage and solvency of FTX. Due to these revelations, Binance, the world’s largest crypto exchange, sold its entire position in FTX tokens, roughly worth $529m. This led FTX into a liquidity crisis as customers attempted to withdraw $6bn following the coinbase report. Furthermore, a short-lived promise to rescue the firm from Binance also fell through days later when corporate due diligence raised concerns about the mishandling of customer funds and other issues. Finally, Bank-Friedman stepped down as CEO of FTX on the 11th of November and FTX filed for Chapter 11 Bankruptcy on the same day.

This led to Sequoia Capital having to write off their entire $214m investment in FTX. Doug Leone, a partner at Sequoia, released a statement saying there was not much the firm could have done to predict the solvency crisis. However, with Sequoia’s portfolio companies listed in the US last year having lost more than $7.7bn in market value since their debuts, fund investors were enraged with the oversight and lack of due diligence regarding FTX. Following this, a rare conference call was called addressing a broader group of investors and apologizing for the investment, however partners stayed firm in the belief that they were misled by Bankman-Fried.

The losses from the FTX crash will no doubt affect Sequoia’s investing principles in the short-term, partner Doug Leone hinted at a startup conference in Helsinki. “I can tell you that in the next 3 to 6 months we are going to dream a little less” he said after describing that Sequoia is in the dream business with entrepreneurs. Until earlier in November, FTX had a prominent place on Sequoia’s website with articles positively describing Bankman-Fried and partner quotes including “I LOVE THIS FOUNDER”. Since then, all articles about FTX have been taken down, as well as other crypto centered articles with references to fast decision making.

Nevertheless, although the FTX crash stirred a lot of controversy within Sequoia and the rest of the industry, Sequoia will continue to invest in tech and crypto startups in which they see potential. Doug Leon stated “Like having a child, you forget the pain of having that child three months later, a year later. We want to be in a dream business.”.

This unexpected loss came at a time of already high uncertainty for venture capitalists.

As valuations of tech giants such as Meta, Alibaba and many more stumble, there may be a cascade effect on the entire tech industry, dissuading smaller players from pursuing IPOs and overall cornering the VCs with stakes in such companies.

VC Boom in Technology Investments

The economy is changing because of technology, and VC is the engine behind this change.

Technology played a major role in the rise in VC investments over the last ten years. According to research from Bain & Company, from 2010 to 2020, the vast majority of VC funding across all deals by independent VC firms and corporate venture capitalists went to digital startups.

After the Covid-19 pandemic, investments in VC boomed. There has been a definite trend toward technology companies obtaining a larger proportion of VC funding. More than twice as fast as other industries, the total value of venture investments in the technology sector nearly doubled in the first quarter of 2021 compared to the same period in 2020. In that period, roughly 70% of all VC investments went to technology startups.

It should come as no surprise that VC investors favor tech companies. In fact, VC funds are looking for short time horizon investments that show a potential to produce significant returns on invested capital. Tech startups have distinctive qualities that make them more appealing to these needs compared to established industries. Indeed, they can grow quickly by leveraging technology, require little capital to start, are generally capital efficient to scale, and can create barriers to entry for rivals that enable the creation of a valuable firm.

Due to the high degree of competition we have just seen among venture capitalists, during the recent startup craze, investors have given firms huge sums of money in deals with ever-generous terms.

As a result, more than 1000 companies were valued at at least $1bn, even though many were still far from being profitable. The possibilities for startups that were preparing for their own IPOs have now narrowed as a result of the collapsing share prices of established tech firms. This resulted in venture capitalists moving more carefully, slowing down and reducing the flow of investments. Consequently, these cash-burning startups have turned to the debt market to retain liquidity and survive.

Explaining the Slowdown

According to Eric Vishria, Partner at Benchmark Capital, one phrase that best describes the situation of the recently inflated market is the fear of missing out, abbreviated simply as FOMO. Attractive and high valuations as well as the shortened due diligence periods and loosening protective measures that investors normally put in place to safeguard their investments are among a few of the reasons. According to Vishria, it was the steady economic growth and financial conditions that followed the 2008 financial crisis. These had encouraged companies to hold their shares and distribute them at a later date. Historically, according to Don Butler, Managing Director at Thomvest Ventures, there has always been a longer delay in the private market’s response to a downturn in the public market. In 2008-09, it took about six to nine months for the private markets to react to what was happening on Wall Street. Why it is happening more rapidly this time, Butler argues, is probably the result of the stakes that have been raised as well as the inflation we’re facing.

Phil Libin, a venture capitalist and former CEO of the note-taking app Evernote mentioned that the incentives have been to keep companies private while increasing the rounds of funding. All this led to a bloated venture capital industry in which startups stayed private much longer than usual before going public. The size of funds grew immeasurably as larger and larger amounts of capital were made available. Investment discipline also loosened as venture capitalists spread their bets across entire sectors rather than trying to pick the few big winners that traditionally accounted for the lion’s share of the industry’s profits.

How Startups are Coping

The plummeting share prices of mature tech companies and the slowed pace of venture capitalists writing checks, have dampened the outlook for startups that were working towards an IPO. Leading many startups to increase their amount of debt, benefiting from low interest rates. Data from PitchBook Data, Inc. shows that volumes in the US in the first six months in 2022 have increased by 7.5% compared to the same time period in 2021, while funding has decreased by 8% over the same period. Hence, big financial companies are currently expanding into venture debt. Blackstone, for example, plans on lending $2bn to growth companies over the next couple of years.

However, debt is naturally also associated with costs and risks. Startups often fail, leading to the inability to meet financial obligations towards investors. Once successful startups such as Ouva Inc. have pointed to debt as the main cause of their failures. “I’ve never seen venture debt save a company,” said an investor from a major Silicon Valley-based venture firm in an interview with Bloomberg, “But I’ve seen it screw them up”. In an interview conducted by Bloomberg with Ross Ahlgren, a partner at Kreos Capital, one of Europe’s largest providers of venture debt, Ahlgren argues that there are secure ways to proceed. For instance, he tends to focus on high-growth companies with healthy unit economics where they can scale over time. Accordingly, he believes that the impression that this is a high-risk business is exaggerated – “The average recovery of distressed companies is much higher than expected in our portfolio.” says Ahlgren. However, caution is advised, as some investors fear that the growing debt market may lead startups to stay afloat, leading them to postpone much-needed decisions instead of taking serious measures.

Outlook

Tech startups will now have to find alternative funding strategies to survive the drought of cash from VC investors. The best alternative would be to get to cash-flow neutral, yet this is not an option for many startups. Another possibility would be to wait on raising, especially in light of the successful fundraising in the last year, when times were good. In any case, as competition for funds intensifies, there will be a selection process for which only the most resilient firms will last.

While from the VC investors point of view, a more robust due diligence process will need to be in place and an all the more selective investment process is ahead. In conclusion, in the ever booming world of tech startups investing the party is over, for now.