The path to exit

A sell-off in public markets, starting in late 2021, was the first effect of the compounding set of factors that changed the macro environment. As these macro factors compounded and drove further sentiment change and capital reallocation, the sell-off has continued and does not, yet, show clear signs of having bottomed out. This sell-off has seen the median enterprise software multiple of enterprise value to forward revenue decline from a peak of 10.9x to just 5.8x. High growth software companies are valued on the basis of their forward-looking cashflow generation and investors are currently placing a higher discount on the future value of upcoming cashflows.

The shift away from the market’s long standing appetite for growth-at-all-costs towards a focus on growth efficiency is reflected in what is now correlating with premium multiples in the public markets. The market is prepared to reward companies that are growing quickly and generating strong cashflows, as seen here by the multiple premium, at 8.8x, enjoyed by companies in the top quartile for revenue efficiency (defined in this case as unlevered free cash flow margin to revenue growth). At the point of publication, multiples on both a median and top quartile basis are trading below their 10-year historical average.

We asked founders which factors they believe will positively and negatively influence their ability to raise capital during the next 12 months.

Across all company stages, founders most often cite their growth rate and financial metrics as the factors likely to have a negative impact. Cash burn and capital efficiency are also frequent answers. The more late-stage the business, the more likely the founder is to be concerned about hitting key milestones, with 16% of Series C founders saying their ability to do so could negatively influence their next raise, compared to just 9% of Series B founders.

As for the factors that can have a positive impact, progress against key milestones is the most cited across the board. For founders of early-stage companies (Series A and earlier), business growth rate is the second most important factor, while for founders of Series B and Series C companies, operational metrics, unit economics, and sales efficiency are all commonly cited.

Bridge rounds are typically more prevalent at the earliest stages of a startup's fundraising journey, when bridge rounds are commonly used to buy more time to find product-market fit. Data from the most recent available quarter, however, highlights that later-stage founders are now raising bridge rounds at the same proportionate rate as those at earlier stages.

This demonstrates one way that founders have responded to the current and anticipated changes to the fundraising environment - by opportunistically raising additional capital as extensions to existing rounds to strengthen their balance sheets and extend their runways.

These extensions to existing rounds, typically at flat valuations, come at the cost of increased dilution for the existing shareholder base, but take advantage of investor demand (often led by insiders) to reinforce balance sheets at a time when cash and runway optionality are critical.

We asked VC respondents to share their reflections on how the market environment is impacting their portfolio. Looking at responses by different types of managers (i.e. solo GPs vs. emerging managers vs. established managers), a greatest number of respondents from all groups highlighted longer fundraising processes, slower investor decision-making, and more frequent bridge and extension rounds as the most biggest changes in market dynamics.

Interestingly, VC respondents from established fund managers were significantly more likely than other respondents to highlight delayed exit timelines as an observed change. An increase in repricing and pulling off term sheets was only highlighted by a small number of respondents across all categories. 

The total exit value stands at close to $75B in 2022, a 35% decrease versus 2021. It includes $33B from announced M&A exit value, $8B via IPOs and direct listings and $33B via SPACs. The SPAC value is primarily driven by Polestar de-SPAC in the summer which represents 80%+ of the total value exit value of SPACs. Overall $46B (61%) can be attributed to VC-backed companies.

IPOs have been one of the biggest casualties of highly uncertain and volatile public markets and negative public market sentiment. The data is stark. There have only been three tech IPOs with a market cap in excess of $1B in Europe and the US this year. This compares to 86 during the bumper year for IPOs of 2021, representing a 30x reduction in volume.

This, of course, has significant knock-on effects for the overall ecosystem in terms of capital liquidity, both from the perspective of the ability to tap the public markets for capital, as well as in terms of the ability for existing shareholders to crystallise value by exiting holdings and distributing or reinvesting any capital gains elsewhere. It remains to be seen when capital market conditions may turn more favourable and enable a partial or full opening of the IPO window.

Looking back across the last five years, 2021 was an outlier year for both Europe and the US, with more than 230 tech IPOs occurring in a single year. 2022 has been a very different story, with only 26 tech IPOs to date. Even when comparing against the period 2018 - 2020, this represents a significant fall in IPO volumes. Across 2018 to 2021, there has been an average of 10+ IPOs a month across both the US and Europe. This is down to 2 per month in 2022.

The US has historically lagged behind Europe in number of tech IPOs - a trend which has continued this year, with only four of the total 26 IPOs.

There have only been three tech IPOs with a market cap in excess of $1B in Europe and the US this year. This compares to 86 during the bumper year of IPOs of 2021, representing a 30x reduction in volume.

This, of course, has significant knock-on effects for the overall ecosystem in terms of capital liquidity including the ability to tap the public markets for capital and for existing shareholders to crystallise value by exiting holdings and distributing or reinvesting any capital gains elsewhere. It remains to be seen when capital market conditions turn more favourable and enable a partial or full opening of the IPO window.

While growth has been the key metric for tech investors in the recent past, it is increasingly profit - or a demonstrable path towards it - that takes precedence in investment decisions. This trend can be seen on the global scale, in the significant difference between profitable and non-profitable companies' performance in 2022. Profitable public companies' market caps fell on average 33% globally, whereas non-profitable ones fell 41%. Interestingly, performance in the European market appears more agnostic to profitability than the wider market: the market cap of its profitable companies actually fell more than those of non-profitable companies (43% and 37%, respectively). Compared to global levels, a higher proportion of Europe's listed companies are also non-profitable (67% compared to 40%). This is, in part, a reflection of the fact that European exchanges enable European companies to list at a more nascent stage in their development, thanks to exchanges such as London's Alternative Investment Market and the Nasdaq First North.

When assessing whether SPACs provide an alternative route to market for European tech companies, the after-market performance must be considered.

In all periods except 2022, de-SPACs have been followed by approximately 30 percentage points worse performance compared to IPOs in the same years. The de-SPAC cohort of 2021 has the worse performance, with Babylon and Cazoo down 95% and 97% respectively.

With a material amount of capital still sitting in SPACs across Europe, it will be interesting to see whether these underperforming de-SPACs will lead to shells returning capital to investors, instead of completing a combination.

Given the current market, and macroeconomic and geopolitical environment, it is not surprising that the exit environment for existing portfolio companies – and their valuations – are considered by many to be the two greatest challenges for VC GPs going into 2023. The health of the ecosystem is dependent on fluid capital markets: capital has to flow from – but also back to – LPs in order to ensure liquidity and returns.