Eugene Zhang, founder of Silicon Valley VC firm TSVC Spencer Greene, general partner of TSVC
Eugene Zhang, a veteran Silicon Valley investor, remembers the exact moment the market for young startups peaked this year.
The firehose of money from venture capital firms, hedge funds and wealthy families pouring into early-stage companies reached absurd levels, he said. A company that helps startups raise money had an oversubscribed round at an absurd $80 million. In another case, a small software company with barely $50,000 in revenue was valued at $35 million.
But that was before the turmoil that hit listed technology giants at the end of 2021[ads1] began to reach the smallest and most speculative startups. The red-hot market suddenly cooled, with investors dropping out in the middle of funding rounds, leaving the founders high and dry, Zhang said.
As the balance of power in the startup world shifts back to those holding the purse strings, the industry has settled on a new math that founders must accept, according to Zhang and others.
“The first thing you have to do is forget about your classmates at Stanford who raised money for  valuations,” Zhang tells founders, he told CNBC in a recent Zoom interview.
“We’re just asking them to forget the last three years that happened, go back to 2019 or 2018 before the pandemic,” he said.
That equates to valuations roughly 40% to 50% of their recent peak, according to Zhang.
‘Out of control’
The painful adjustment shaking through Silicon Valley is a lesson in how much luck and timing can affect the life of a startup—and the fortunes of founders. For more than a decade, bigger and bigger sums of money have been thrown at companies across the startup spectrum, inflating the value of everything from small pre-revenue outfits to still-private behemoths like SpaceX.
The low interest rate era following the 2008 financial crisis led to a global search for yield, blurring the lines between different types of investors as they all increasingly sought yield in private companies. Growth was rewarded, even if it was unsustainable or came with a bad economy, in the hope that the next Amazon or Tesla would emerge.
The situation reached a fever pitch during the pandemic, when “tourist” investors from hedge funds and other newcomers flocked to funding rounds backed by name-brand VCs, leaving little time for due diligence before signing a check. Companies doubled and tripled their valuations in months, and unicorns became so commonplace that the term became meaningless. More private US companies achieved at least $1 billion in valuation last year than in the previous half decade combined.
“It was a bit out of control in the last three years,” Zhang said.
The beginning of the end of the party came last September, when the shares of pandemic winners including PayPal and Block began to plunge as investors anticipated the start of rate hikes by the Federal Reserve. The next hit was the valuations of pre-IPO companies, including Instacart and Klarna, which plunged 38% and 85%, respectively, before the doldrums eventually trickled down to early-stage startups.
Difficult as they are for entrepreneurs to accept, valuation haircuts have become industry standard, according to Nichole Wischoff, a startup executive turned VC investor.
“Everyone is saying the same thing: ‘What’s normal now is not what you’ve seen in the last two or three years,'” Wischoff said. “The market is kind of marching together saying, ‘Expect a 35% to 50% decline in the last couple of years. It’s the new normal, take it or leave it.”
Beyond the headline-grabbing valuation cuts, founders are also being forced to accept more onerous terms in funding rounds, giving new investors more protection or more aggressively diluting existing shareholders.
Not everyone has accepted the new reality, according to Zhang, a former engineer who founded venture firm TSVC in 2010. The outfit made early investments in eight unicorns, including Zoom and Carta. It typically holds onto its holdings until a company goes public, although it sold some positions in December ahead of the expected decline.
“Some people don’t listen, some people do,” Zhang said. “We work with people who listen, because it doesn’t matter if you raised $200 million and later your company dies; nobody will remember you.”
Along with his partner Spencer Greene, Zhang has seen boom and bust cycles since before 2000, a perspective that today’s entrepreneurs lack, he said.
Startups that need to raise money in the coming months will have to test the appetite of existing investors, stay close to customers and, in some cases, make deep cuts, he said.
“You have to take painful measures and be proactive instead of just passively assuming that the money will show up one day,” Zhang said.
A good vintage?
Much depends on how long the downturn lasts. If the Fed’s inflation-fighting campaign ends sooner than expected, the money drain could reopen. But if the downturn extends into next year and a recession hits, more companies will be forced to raise cash in a tough environment, or even sell themselves or close up shop.
Zhang believes the downturn is likely to be prolonged, so he recommends that companies accept value cuts, or downgrades, as they “could be the lucky ones” if the market continues to tighten.
The flip side of this period is that bets made today have a better chance of becoming winners down the road, according to Greene.
“Investing at the seed stage in 2022 is actually fantastic, because valuations correct and there’s less competition,” Green said. “Look at Airbnb and Slack and Uber and Groupon; all these companies were formed around 2008. Recessions are the best time for new companies to start.”