Where Tech Downturn Slows Early-Stage Startup Funding

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.

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.

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.”

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.

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.