The Current State of Australian Venture Capital (and how we got here)
Markets and investment cycles
Markets. They go up, down and sideways. The direction that they take and the velocity at which they move, is in a constant state of flux as prevailing market conditions change. Market cycles have typically been broken down into five key phases; early upswing, bull market, peak, bear market and trough. Once a trough has formed, sure enough the next early upswing will appear, and the cycle starts again. When markets are moving up — greed is usually the predominant emotion on display, and when they are down — investors are generally fearful.
And so, while the phases of an investment cycle are well understood, the timing of both the individual phases within a cycle and the length of the cycle itself are harder to pin down. The challenge in predicting investment cycles, is that human behaviour is not purely rational following a clear sine wave. The result is a market that is akin to a living and breathing organism consisting of geopolitics, commodity prices, regulatory changes, interest rates, economic conditions, technological change and investor sentiment. This all leads to unpredictable fluctuations that we commonly refer to as volatility. But despite the pain or fortune they transport upon their subjects — investment cycles are neither ‘good’ nor ‘bad’ but rather an aggregation of the characteristics of a particular market that shape the behaviour of its participants. All markets experience investment cycles — from venture capital to real estate to avocados. For the vast majority of assets, it is generally accepted that, their cycles are driven by supply and demand.
During the avocado shortage of 2019, the green fruit attracted prices of up to $8 a pop but now, after years of investment in orchards, resulting in an abundance of supply and no real shift in consumer demand, they can be snapped up for not much more than $1.
With supply constraints and demand for Australian residential property at an all-time high off the back of an unprecedented period of low interest rates — property prices went through the metaphorical roof. But now with rates going up — demand for real estate has cooled, resulting in a softening of prices.
It is clear to see in the above examples that when demand outstrips supply, prices of the underlying assets go up — but it works a little differently in venture capital.
Did we just hit peak VC?
Within venture capital, demand is essentially the amount of capital prospective portfolio companies are seeking and supply is the amount of capital held by the venture investors that is available for these companies.
When the supply of capital is low, it is reflected in more conservative valuations (that benefit the investor) and a larger number of companies missing out altogether. When the supply is high, the inverse is true — valuations increase, and a higher number of companies will generally get funded.
Total capital raised within the Australian venture eco-system in 2021 cleared the $10 Billion mark for the first time. This was an increase of more than 3x on the average capital raised by the market across the years 2018–2020. Sentiment could not have been higher coming into 2022.
As a result of this, some companies received funding, that might not have previously made the cut. Rounds also got bigger (whether the capital was needed or not) which meant valuations were forced to increase. Fundamental data became secondary in importance, as far as valuations were concerned, replaced by froth, FOMO and the needs of investors to deploy capital.
If the supply side remained buoyant and sentiment upbeat, things would have certainly continued on their merry way but that is not in the nature of cycles. Once predispositions shifted and the mood changed, a supply shock was always going to hit the system.
Our friends at CutThroughVentures have quantified this for us; reported venture capital investment in Australian tech firms fell anew in June 2022, down 52 per cent from the prior year corresponding period and almost 10 per cent lower than in May 2022.
While the number of investible start-ups Australia is producing is without a doubt on the rise, there are only so many local companies that can ingest the big capital injections that were required for this ocean of capital to be put to work.
There is also no question that the Australian start-up eco-system needs more investment, but the capital allocation process should be a patient and considered one, not one where the fastest money at the highest valuation wins. Maximising valuations should absolutely be a factor for founders when they are pricing their rounds, but artificially high valuations provide stakeholders with unrealistic expectations of where a business is at and founders with too much cash to burn, that often sets them up to fail.
Public to private
Venture capital valuations will usually take direction from the public markets, so it was unsurprising to see once public technology valuations started crumbling, the private markets were affected. What is surprising though, is perhaps the speed at which the paradigm shifted. The Thomson Reuters Venture Capital Index has sunk by around 60% in the space of a few months.
So very quickly, we have gone from existing in a market that was extremely supportive of private companies and their capital aspirations, to hitting an inflection point and coming out the other side into an environment that is now highly precarious for founders.
Private investors are applying more caution to their decisions which is manifesting into smaller rounds, at more conservative valuations. The excesses of years gone by have come to an end and have been replaced by a prudence not visible within the larger investor community since 2016.
IPO markets have also gone into hibernation, removing an important source of capital and liquidity for many private companies and their backers that will only amplify the current squeeze
Cash is king
Whether you’re a big company or a small company, there is only one way to go out of business and that is to run out of cash. This usually coincides with an unsuccessful raise that is unfortunately becoming a reality for a growing number of companies. In the last few months, countless high-profile companies have had to reduce their cost bases by laying off employees and Volt, Send, Sneakerboy plus a myriad of others have shut their doors for good.
Thousands of people have found themselves out of a job and are now seeking employment elsewhere. No company and therefore no portfolio is immune to the current shocks working their way through the market.
The good news on this front is that there is still huge demand for high quality talent and so you would expect that a large number of these individuals will find a new home quickly.
The local crypto sector has also obviously been hit hard with massive layoffs across a range of well-known companies that, until recently, were enjoying one of the most spectacular booms the world has ever seen. It is impossible to know how long the crypto freeze will last for, but you would think the list of companies making redundancies is only going one way.
Managing cash flow is no doubt one of the biggest challenges for high growth start/scale-ups. And companies these days are under enormous pressure to continually meet aggressive growth targets, which is sometimes only amplified by return hungry investors.
However, with this in mind, there comes a time when founders and management teams need to honestly ask themselves; is what we are doing sustainable or is the cash burn we are currently experiencing feasibly going to get us through to our next capital raise? If the answers are no — founders and boards need to make difficult decisions as early as possible to ensure that they live to fight another day. Here’s hoping that the companies who have made these tough calls have done enough to ensure their survival.
What has become patently clear is that, for large loss-making companies in particular, capital is not an evergreen commodity that can be called at will. To assume it is, is no different in a sense to the hot hand fallacy (only with more significant consequences).
Where to next?
Obviously for the owners and employees of the companies that haven’t survived, the last few months have already been extremely painful. Time and capital invested have been lost and promising journeys have come to premature ends.
However, as difficult as they are, cycles are needed so that efficient companies are able to demonstrate their credentials and rise to the surface. Capital is a scarce resource and so over the course of a cycle, it should be allocated to the companies who can utilise it to the best effect and to the benefit of their owners.
Companies that are burning large amounts of cash, even the high-growth ones, are now reigning things in. Broad stroke strategies requiring investment on multiple fronts will be revisited and rationalised. The old-fashioned approaches of growing sustainably and managing cash-flow are very much back in vogue. As are companies with measured hiring processes who have a strong understanding of their unit economics and profit levers. There has never been a better time to be a ‘pain-killer’ company providing genuine utility to customers.
But contrary to what is being reported by a number of pundits — the venture capital market is not dead. Markets transitioning between phases of the cycle can be rough. They can be very rough. And although it can feel like the end, it is not. Rounds will go unfilled, term sheets will be pulled, and valuations may be revised down =but that is the nature of start-up land. These occurrences may become more common, but they are nothing new.
Big valuations are also not gone. However, it is highly likely that the companies looking for capital at lofty eight and nine figure numbers are going to need more than a colourful deck and a roadmap to get them done. These bigger valuations will be reserved for businesses that are able to display genuine traction, strong cash flow and sustainable unit economics. These are the things that are going to get investors excited. Of course, there will be outliers, but you would expect the overwhelming majority of companies in this league to exhibit these sorts of features.
It also has to be noted that plenty of ultra-successful companies have been borne during difficult economic periods. Businesses that have had to do more on less are often well equipped to deal with the inevitable capital squeeze around the corner. As they say: necessity is the mother of invention and that is never more evident than during times such as these.
It can’t all be bad
The universe of companies that have recently closed decent rounds should consider themselves either extremely astute, very lucky or a combination of the two. They are now well-placed to crack on with the job of growing their business. However, I would expect that even companies in this category will be reviewing their cash flow forecasts to make sure they have enough time to achieve their desired milestones that unlock additional capital.
On the positive side, there is still a large amount of dry powder sitting within the eco-system that needs to be invested, which means capital will continue to trickle into the companies that can stand out from the crowd. There will be a clear flight to quality and valuations will be scrutinised by investors in ways many current founders have never known. As relative valuation methodologies come to the fore, each additional round is used to price many more, which results in a somewhat virtuous cycle of downward pressure on valuations.
But is has to be noted that the Australian eco-system is in pretty good shape compared to some of the larger offshore markets. The tail winds of recent years (government assistance, eco-system support, talent density, etc.) are still strong which means the venture capital fly-wheel will keep spinning which will ensure that our system continues to produce high-quality companies. And the Australian markets immaturity and relative value it contains against the more developed markets - should, in theory, mean that there is a shorter distance, peak to trough, for it to fall.
There is still a long, winding road ahead. Many more companies will not survive, but at the same time — many well-built, efficient companies with resilient founding and management teams will continue to flourish and demonstrate true value to both their customers and owners.
As always, investing for the long term, as is required in venture capital, is the best way to protect oneself from the fluctuations that market cycles throw up. More than ever, it is important to focus on the larger trends at play and to invest with a high level of conviction.
Warren Buffett famously declared; ‘buy when others are fearful’ — the current landscape may represent a golden opportunity to do just that.