Introduction

We all know 2021 was a year when funding start-ups resembled a race, characterised by ever-lower bars for funding and sky-high valuations. However, when public market multiples collapsed, later-stage private investment came to a grinding halt. Despite the public market largely recovering, start-ups seem to still be facing funding crunches.

From my perspective as an LP and an angel investor, the nature of funding crunches over the last two years has evolved. It is arguably more difficult for start-ups to secure funding today than it was a year ago, and with good reason.

Multiple Compression Induced Funding Crunch

The public market crash of 30% - 40% in 2022 wasn’t due to a sudden drop in public companies’ earnings, but rather a compression of multiples on earnings. Stock prices for companies earning the same revenues faced similar discounts due to this multiple compression.

Given that the valuations of later-stage start-ups are anchored to public market multiples, a public market multiple compression naturally impacts later-stage funding rounds. Once the pipeline stops, the impact travels to earlier rounds. However, it wasn’t all doom and gloom for early-stage start-ups. As later-stage VCs stopped funding later-round private companies, they began to look earlier to deploy capital into start-ups not as tied to the public market. While this offered some liquidity, it was arguably unhealthy as it prevented early-stage valuations from converging to the new normal.

However, liquidity from later stage VCs is not permanent as their deployment windows pass by, and at the same time, the macro market starts its dramatic shift, making funding more expensive.

The Missing Equity Risk Premium in the Private Market

If the multiple compression-induced funding crunch is channeled through VCs, the current crunch resulting from macro environment changes is channeled through further upstream funding sources, such as LPs.

In Australia, when the cash rate increased from 0.1% to 4.1%, investors began assessing risky investments differently. Now major banks subordinated notes can return 7% p.a., using private market language, the DPI over 10 years will be around 2X; considering start-up secondaries’ discount is 30% - 50%, this roughly equates to TVPI between 2.86 and 4, which is obviously top quantile VC performance in today’s standards, not even accounting for the fact that VCs haven’t marked down their portfolios to a fair degree. The public market’s equity risk premium is over the cash rate so it can still expect to generate good returns with higher risks. Even with the equity risk premium, the public equity market is still losing popularity to fixed income instruments - a staggering $5 billion flowed into bond ETFs in Australia during the last 12 months according to Stockspot’s July 2023 update.

This is not good news for start-ups (and VCs), because to retain the level of interests in the private investing space, start-up investments need to generate a sufficient level of risk premium over cash rate to make it worthwhile. In the public market, the equity risk premium is robust across different macro regimes. What about start-up investing? For early stage start-ups, the macro environment almost does not matter as per YC. The largest risk for investing in early stage start-ups is actually execution risk.

If investors start to demand a higher level of premium, it impacts start-ups in several ways:

• Valuation: Valuations have to come down significantly compared to similar companies raised during the low interest era

• Capital Efficiency: Start-ups need to be leaner and more capital efficient, hitting the same goals with less capital

• Default Alive: Start-ups need to become hard to kill, even if the latest funding becomes their last round of funding. Wise old advice provided by Paul Graham

• Higher Bar: Less capital simply means that not everyone will be funded. ‘Better’ start-ups will be prioritised in funding in terms of return potentials. No brainer pathway is to become a ‘better’ start-up in the pecking order of return potentials

Interestingly all above look exactly like advice, but they are not. They are merely first order derivatives of what investors need in a higher interest environment, which is more than fair.

Conclusion

It might be easy to trash investors as ‘dumb’ when they react to low traction and high valuations presented by start-ups. However, most of the capital deployed in start-up investing is sophisticated or even institutional capital, often part of a bigger portfolio strategy where the risk-return trade-offs and co-variance between different asset classes are considered. If a ‘fair’ premium can’t be asked for, it means a lower allocation to unlisted assets and subsequently, fewer start-ups being funded.