2023 Annual Report
A downturn, but not Armageddon
2023 marked a turbulent year for the venture capital and startup landscape. Excluding the $10bn OpenAI raise, venture funding declined 38% compared to 2022. Of fundings that closed, 20% were down-rounds, the highest percentage since the GFC. Tech layoffs were a continuing theme of the year, as over 262,000 tech employees were laid off throughout 2023. Deal volume across sectors cratered.
Fundraising also took a hit. VCs raised $67bn in 2023, the lowest annual amount since 2017 and a 60 percent decline from 2022. Institutional investors overallocated to venture capital during the bubble, and have been left with little room for new or upsized commitments to funds. Even household names like Andreesen and Tiger Global have had to reduce fundraising targets.
In many ways, 2023 was a tale of two different markets between early-stage and later-stage VC. Seed and Pre-Seed funding remained robust, with deal sizes and valuations at 10-year highs. Series A rounds were down from 2021 highs but still remain elevated compared to pre-2021 valuations and check sizes. Late-stage VC has been a different story. Every day brings news of a new unicorn failure. Convoy, a digital freight broker, shut its doors in October, after being valued at $3.8bn less than a year ago. WeWork filed for bankruptcy. Bird Scooters delisted from the Nasdaq. The list goes on and on. Late-stage pre-money valuations fell 16% over 2022 and are at multi-year lows. Newsworthy blowups and a closed IPO market have caused investors to be more hesitant on larger deals, with only the highest quality late-stage companies getting funded in this market. Unicorns that IPO’d or SPAC’d have performed terribly, souring public investors on VC-backed equity offerings.
However, while we’re in a pullback, we do not expect Armageddon. Most companies we spoke to continue to see strong demand for their products across sectors. Credit quality held up better than expected, the 5 public venture debt BDCs recorded a combined portfolio markdown of only 2% of principal loan values. SVB and the string of startup-focused bank failures at the beginning of the year did not spread contagion throughout the system like many of us initially thought it would. Although most venture funds are going to report negative paper returns for the year, we still see VCs building disruptive businesses and are confident many will generate long-term successful outcomes.
Golden age of fraud
In 2020, Jim Chanos said “we are in a golden age of fraud”. MBM agrees, and we’re seeing the fallout. While FTX and Nikola dominated the headlines, the rot is everywhere. As our partner Lauren Bonner was recently quoted in Bloomberg, “we’re seeing a lot of naughty behavior.” This past year alone, roughly 5% of our deals were ones in which we suspected fraud.
As special situations investors, we are not necessarily scared of fraud if it has been acknowledged and we have the right opportunity to clean house and acquire real value. However, we saw a lot of current issues. We met with well-trained CFOs, whose resumes include bluechip banks, “miscalculating” cost of goods and inflating margins. We saw these same CFOs, alongside the founders, claiming one-time revenue as subscription revenue.
One might be able to look past those examples as just the fruit of the poisonous venture growth model, but there was more. At least five companies came to us desperate for cash after their venture investor submitted a termsheet without having the capital to meet the commitment, only to rescind it at the last minute. We saw questionable related party transactions that looked a lot like self-dealing, channel stuffing and insider loans booked as revenue. Fellow investors have shared stories of CEOs being fired for reporting false figures and misrepresenting the state of a business, and many have initiated indemnification claims against sellers. In one particularly egregious case, we caught a company maintaining two sets of books.
Why so much persistent fraud? Our view is that (1) given the funding crunch, startups are more desperate to raise money than ever, and thus willing to tell investors whatever they need to hear to get money in the door, and (2) during the recent venture boom, many investors took a looser approach to due diligence and corporate governance in order to avoid missing out on the next big thing. Boards are taking a sharper approach today, and we believe we’re ushering in the Age of Governance (at least we hope so!).
So how did VCs and startups respond to these market conditions?
Many companies exited 2021 with unsustainable cash burns that were justified by low interest rates and the confidence that additional funding would be there when they ran out of capital. With the decline in funding, companies have had to find ways to extend runways and operate capital efficiently. Cash flow, profitability and balance sheet quality entered the venture lexicon for the first time in many years. VCs pushed portfolio companies to conserve cash and moderate growth in favor of profitability. Companies laid off engineering and product headcount and pulled back heavily on customer acquisition spend. On the funding front, well, as Jeff Goldblum famously said in Jurassic Park, “Life, uh, finds a way”. Investors cobbled together inside rounds or found short-term bridge financing solutions to keep companies afloat until market conditions improve. Founders even lent money to their own companies. Lenders became highly accommodative, and through a combination of halting amortization payments, PIK’ing interest, extending maturities and waiving covenants they kept their credits out of bankruptcy. Many startups had to resort to alternative and expensive forms of short-term credit such as receivables factoring and esoteric asset-based loans.
Common themes in distressed companies:
Disconnect in valuation expectations: Many startups raised more capital than they needed at unsustainable valuations in 2020 and 2021. Founders expect future raises to be at or above these elevated valuations, but right now there is a massive bid-ask spread between that and what investors are willing to do. We’ve seen companies with <$3m of revenue who raised at valuations as high as 50x revenue multiples in the bubble. Even though some of these are solid businesses, their fundraising is stuck because investors/founders are unwilling to take a markdown.
Stakeholder Tension: When everything is progressing and up and to the right, stakeholders are happy and aligned. When things are uncertain, stakeholders begin to focus on protecting their own piece. We see many scenarios where the founder, investors and the lenders are at odds with each other. Each usually has some kind of leverage or blocking rights on a transaction, which has prevented many startups from finding a capital solution.
Unsustainable business models: You can only sell a $1 for 50 cents for so long. During the bubble, many companies launched cool products with broken economics, essentially causing investors to subsidize customer value. When we see a new business we always ask ourselves “would we acquire this business for free?”. Frighteningly often, the answer is no.
Sectors of elevated distress
D2C Consumer Brands – 25% of all distressed opportunities we saw were D2C brands, by far the largest single category. Food and apparel were hit particularly hard. So how did we get here? D2C brands came onto the scene in the early 2010s with promises to disrupt traditional retail. D2C startups achieved massive success quickly, and winners were minted in every category. Warby Parker for glasses, Allbirds for shoes, Away for luggage, Casper for mattresses, and many more that became nationally-renown brands. From 2016 – 2019 numerous competitors entered all of these verticals, chasing the success of earlier entrants. Offering largely similar products, these brands followed the same playbooks and competed for the same customers. Bidding on the same keywords and impressions drove CAC up to unsustainable levels. This likely would have come to a head sooner, but COVID came and went and the resulting e-commerce bump juiced revenues across the industry and allowed a lot of these brands to stay alive longer than they should have. Brands got stuck in a death loop post-covid. Declining revenues in 2022 and 2023 depressed D2C fundraising, which led to them cutting back on marketing spend to preserve capital, further exacerbating revenue declines. This has been a tough category for us to fund for a number of reasons:
D2C as the brand: Consumers do not care if your brand is D2C, they care if you have a good product at a good price point. We saw many brands that were D2C for the sake of it without any real innovation.
Soft differentiators: Brands approached us with largely undifferentiated products claiming they were different because they are authentic, sustainable, ethical, carbon neutral, transparent or our favorite, “customer centric”. Many of these are admirable and make for great conversation, but we are not convinced the consumer cares enough about these kinds of attributes to give someone a sustainable brand advantage (yet).
Subscriptions: Every company wants subscription revenue. Consumer products are, for the most part, not the right fit for a subscription model. And if 70%+ of your customers cancel after just a few months, what’s the point?
BNPL/Payments/Lending – It was a common pitch. “We are going to become the Stripe + Klarna for X vertical. We are going to insert ourselves into funds flow and process payments for the industry and add a BNPL option at checkouts. We are then going to take this payment data to develop proprietary underwriting algorithms and begin offering lending products to customers as well”. Compelling right? A few problems we consistently see:
BNPL uptakes have been very, very low for most product categories. I don’t think we’ve spoken to a single company who has materially increased revenue by adding a BNPL payment option
Customers who do use BNPL are likely sub-prime, and do not have enough wallet for fintechs to sell additional products and services into
Attacking new verticals that lack credit availability sounds like a great opportunity, but there is usually a good reason why banks and other traditional lenders do not lend to certain industries/assets/consumers
2024 Outlook
We expect the venture downturn to continue through 2024 and potentially into 2025. Record low VC fundraising last year is going to lead to a shortage of capital available for startups in 2024. The major valuation cuts seen in late-stage VC will likely begin trickling down to earlier stage fundings. Meanwhile, until the IPO market opens up, late-stage VC deals will remain depressed given that there are few viable exit paths. While venture-backed companies found ways to survive in 2023, most had to choose short-term solutions. We agree with Peter Herbet of Lux Capital’s sentiment in a recent Financial Times article, “The days of Band-Aids and hope are behind us, and people are accepting the new reality,” 2023 was a year of just that, band-aids. Eventually insider rounds are going to dry up and VCs are going to begin cutting loose underperforming holdings. Lenders are going to need to begin collecting loan payments. Company’s have only so many tricks to extend their runway, and it feels like most have been exhausted. There are reasons for economic optimism driven by strong consumer spending, moderated inflation and the prospect of lower rates. However, founders are going to need to make difficult operating and funding decisions in 2024 that determine the future of their businesses. Our advice: a down-round is better than no-round. Short term pain can still result in advantageous outcomes for all stakeholders.