Silicon Valley startups brace for a summer of pain

The startup world has had a tough year – plagued by mass layoffs, plummeting venture capital investment and the chaotic collapse of Silicon Valley Bank. But many in tech believe that the worst is yet to come.

As the market downturn drags on and investor cash remains hard to come by, more startups will start to run out of money, experts say. Some venture-backed companies will be forced to raise new funding even if it means agreeing to a lower valuation than they once secured, a deal called a down round, dreaded by founders and investors alike.

“We haven’t had a compression in values like this in more than 20 years. It’s an absolute bloodbath,” said Cameron Lester, global co-head of technology media and telecom investment banking at Jefferies, adding that companies that are able to raise money, even at a lower valuation, are the lucky ones. “What matters is you’re a survivor,” Lester said.

Toward the end of 2022, down rounds hit near five-year highs, according to research firm Prequin. And early data for the first quarter shows roughly 7.5% of all venture funding rounds in U.S. were down rounds, according to PitchBook – a number it expects will climb. High-profile companies like financial giant Stripe, Swedish payments startup Klarna Bank and security firm Snyk have already taken valuation cuts, and others like Blockchain.com are said to be in talks to do the same.

Founders assiduously avoid down rounds because they signal that a company’s to-the-moon trajectory has been derailed, battering morale and wiping out millions, and sometimes billions, of paper wealth for startup founders and employees. They also represent a loss for venture capitalists and their investors, called limited partners, and can result in legal headaches.

Yet ask most tech industry professionals and they will grimly confirm that such deals are becoming inevitable. “We expect down rounds, especially toward the second half of this year, to really pick up,” said PitchBook analyst Kyle Stanford. The coming wave of lower valuations, is “common knowledge,” said Alfredo Silva, a partner at law firm Morrison & Foerster. In March, the firm held a workshop on how to navigate the legal complexities that can come along with such rounds.

While many companies have cut costs and taken on debt to avoid raising money on unfavorable terms, those delay tactics have limits. More than 400 companies – one-third of all unicorn startups, those valued at $1 billion or more – haven’t raised new funding since 2021 according to PitchBook. That’s a long time for a company that isn’t yet turning a profit, coasting on the cash they brought in from previous funding rounds. Most venture backed companies usually raise every year or two, and about 94% of tech unicorns are unprofitable according to PitchBook.

“Some of these companies remind me of Scottish nobility that haven’t raised money in seven generations,” said Mathias Schilling, co-founder of venture firm Headline. “They sit and drink champagne while it rains through the roof.”

Schilling’s advice: “Get real, take the down round.”

Some major startups are already taking the hit. Stripe completed a financing deal valuing it at $50 billion, or about half its 2021 valuation. Several crypto startups have taken or are taking down rounds, as are multiple companies overseas, including Klarna, which saw its value fall more than 85%. Earlier this month, workout startup Tonal Systems raised money from a private equity firm at a reported $550 million price tag, or one-third of its valuation in 2021.

But as more startups are learning, a down round is better than no funding round. Venture investing in all startups has declined precipitously in recent months. The number of startups that raised money in the first quarter of 2023 hit its lowest level in five years – a pace that falls far short of demand. An PitchBook internal estimate shows that for every $3 that startups need, just $1 is being deployed.

“We’re actually in one of the worst times in recent memory in venture activity,” said Avlok Kohli, chief executive officer of AngelList, which offers fundraising and management tools to startups, investors and fund managers. “It’s the lowest activity we’ve seen and the lowest positive activity we’ve seen.”

Driven by battered valuations for publicly traded tech companies, mature startups preparing for an initial public offering were impacted first. Younger startups, still years from public debut, were initially spared. But Kohli said that’s changed in recent months, with the pain trickling down to early companies as well, because no one want to write a check that’s “a bridge to nowhere.”

Investors are becoming more skeptical and driving harder bargains for every startup. That’s true even in the buzzy space of artificial intelligence – a rare bright spot in the venture investing landscape which has been flooded with talent and cash to create new companies. “Is it overheated? Could there be a bubble? Sure,” said Kohli, who’s optimistic about the sector. But he noted that great expectations are a key facet of the world of tech, even though the risks are always high.

“Statistically as a startup, you won’t make it,” Kohli said. “That’s just math.”