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Tech Downturn Slows Early-Stage Startup Funding

Power shifting back to investors after glut of cheap money heightened competition for deals

The Tech Sector Is Taking a Beating. Here’s Why.

Play video: The Tech Sector Is Taking a Beating. Here’s Why.

As markets react to inflation and high interest rates, technology stocks are having their worst start to a year on record. WSJ’s Hardika Singh explains why the sector—from tech giants to small startups—is getting hit so hard. Illustration: Jacob Reynolds

By Berber JinFollow

Updated July 20, 2022 4:25 pm ET

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The slowdown in venture-capital funding has spread to early-stage startups, with that part of the market suffering one of the biggest investment drops in more than a decade.

In the second quarter, venture capitalists invested around $16 billion in U.S. early-stage deals—known as Series A and B rounds—a 22% decrease from the year-earlier period, according to PitchBook Data Inc. That marked the biggest quarterly year-over-year decline in early-stage funding since at least 2010, with the exception of a drop in the second quarter of 2020, when investors pulled back briefly amid the onset of the global pandemic.

The retreat shows investors’ increasing caution toward riskier investments such as nascent companies, a marked change in sentiment from recent years, when competition among venture firms drove them to invest ever earlier in a startup’s life cycle. It follows a similar pullback in funding for later-stage startups, which are closer to going public and thus more affected by stock-market changes.

The change is shifting more power in Silicon Valley back to investors. For years, a deluge of cheap money kept valuations soaring, and venture firms said they spent less time on research and vetting the companies to court founders and not miss out on deals. The pandemic accelerated many of these trends, as demand for software services increased to accommodate businesses moving online and interest rates stood at historic lows.

TEXT

BUSINESS

Tech Downturn Slows Early-Stage Startup Funding

Power shifting back to investors after glut of cheap money heightened competition for deals

The Tech Sector Is Taking a Beating. Here’s Why.

Play video: The Tech Sector Is Taking a Beating. Here’s Why.

By Berber JinFollow

Updated July 20, 2022 4:25 pm ET

TEXT

The slowdown in venture-capital funding has spread to early-stage startups, with that part of the market suffering one of the biggest investment drops in more than a decade.

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Sequoia Capital is among the venture-capital firms to warn of the worsening fundraising environment for startups.

PHOTO: ELIJAH NOUVELAGE/BLOOMBERG NEWS

Earlier this year, venture capitalists remained optimistic about the early-stage funding environment even as the public shares of technology companies ranging from DoorDash Inc. to Snowflake Inc. cratered. U.S. early-stage funding increased 50% in the first quarter compared with the year-earlier period, PitchBook data show.

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That calculus has changed amid a worsening macroeconomic environment and a virtual freeze in investment for more mature, growth-stage startups. Venture firms that focus on early-stage investments typically rely on cash-rich money managers to mark up the value of their holdings in subsequent funding rounds. But many of these large investment firms earlier this year slowed their deal-making or exited the startup market entirely amid the stock market rout, according to venture capitalists, raising the investment bar for younger companies.

Even funding for seed-stage deals, often the first source of outside financing for companies still developing their products, has taken a hit. U.S. deal volume dropped 11% to $3.9 billion in the second quarter compared with the year-earlier period, the first such quarterly drop on a year-over-year basis in almost two years, according to data from PitchBook.

“The seed and Series A funding environment is the toughest I’ve ever seen in my career managing a fund,” said Jeff Morris Jr., who manages a crypto-focused early-stage fund called Chapter One. “It will be painful in the short-term.”

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Amid the chilled environment, investors say even the youngest startups are now being expected to demonstrate they have a clear path to generating revenue and profits. Such metrics weren’t always given priority by investors looking to back new, buzzy companies last year as a record amount of capital and low interest rates fueled a race for returns, they say.

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The pullback in early-stage investment follows a tough few months for more mature startups. Pandemic darlings including instant delivery firm Gopuff and virtual events company Hopin Ltd.—which raised three rounds of financing in less than a year—have had several rounds of layoffs in 2022. Startups across the board are also scrutinizing their balance sheets to conserve cash in anticipation of a worsening fundraising environment, heeding the stern public warnings given by VC firms like Sequoia Capital and Lightspeed Venture Partners.

“In this climate, my mind-set has totally shifted. It’s close sales, close sales, close sales,” said Anurupa Ganguly, the chief executive of two-year-old education-technology startup Prisms of Reality Inc., which is looking to raise a Series A round in the fall. “When things tighten, it forces founders to be far more rigorous.”

Ms. Ganguly said she didn’t believe the market had soured enough to affect her $4.3 million seed round, which she completed in March, but that it will become more important for startups to hit key financial metrics if they want to raise at good terms from venture capitalists.

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Startup Gopuff is one of the tech companies that have had layoffs in 2022.

PHOTO: THOMAS URBAIN/AGENCE FRANCE-PRESSE/GETTY IMAGES

Venture capitalists raised a record $139 billion in U.S.-based funds last year, according to PitchBook, and have already raised $122 billion this year. They include a $1.9 billion early-stage fund raised by Founders Fund in March and a $2 billion early-stage fund raised by Lightspeed Venture Partners in July this year.

The large amount of committed capital means VC firms will still have to search for new startups to back, though the pace of investment could slow down for some funds, said Nina Achadjian of Index Ventures. She said Index’s partners had more time to make decisions on new investments compared with last year, when popular founders often held the upper hand in deal negotiations.

Some seed startups are already struggling to raise Series A rounds, an investment stage where investors typically expect businesses to show clear signs of traction among customers. Many of these companies are now raising extension rounds, capital usually offered from existing investors at the same price as the last round, according to Ms. Achadjian and other venture capitalists.

Crypto startups have been hit particularly hard, in part because of the sharp selloff in established cryptocurrencies like bitcoin and Ethereum. Venture capitalists invested $8.4 billion in global early-stage blockchain startups in the second half of last year as fervor for the nascent sector took off. The numbers have declined sharply since: just $2.4 billion was invested into such companies in the second quarter this year, down from $3.1 billion in the first quarter, according to Crunchbase Inc. data.