Avery Pennarun started fundraising early this year for the company he co-founded, the virtual private network provider Tailscale.

“I think there [were] the beginnings of hints of, ‘Things were coming,’” said the CEO, whose company last week announced a US$100-million Series B raise, making noise in an increasingly subdued venture capital market. “People were definitely starting to get worried by the time we actually signed our term sheet.”

Following some panic at the outset of the COVID-19 pandemic, Canada’s technology sector enjoyed a historic two-year run. Venture capital investors pumped over $14 billion into Canadian tech companies in 2021, a record. Valuations soared and spawned a surge in “unicorns,” private companies valued at over a billion dollars. New and foreign investors flooded the sector, and investors upped their risk tolerance, for fear of missing out on deals.

Now, amid rising inflation, interest-rate hikes and the war in Ukraine exacerbating economic uncertainty, funders are pulling back in what’s shaping up to be the first down cycle in over a decade. “Everyone now is just preparing for a storm,” said Kim Furlong, CEO of the Canadian Venture Capital & Private Equity Association. 

The Logic spoke with 13 venture investors over the last several days. Their consensus: we’re in the middle of the turbulence that precedes a correction. They were less confident predicting how long that turbulence will last, however, with many expecting volatility for at least the rest of the year. 

Here are some themes from those conversations:

A ‘flight to quality’

Venture capital funds raised a record amount of money last year, giving them ample cash to support portfolio companies and back new firms. “VCs are not good at not deploying capital,” said OMERS Ventures managing partner Damien Steel. But they’re now investing with much more caution. “[VCs] did unnatural things in order to keep up with the market last year,” said Steel, dabbling in areas outside their usual expertise. “In 2022, you’re going to see those same venture funds go back to their roots.”   

Real Ventures managing partner Janet Bannister expects to see a “flight to quality,” as investors look for prudent ways to spend their capital. Firms with strong revenue and a clear path to profitability, or that are already profitable, are still well positioned, she said. “The best companies are receiving multiple term sheets,” said Bannister, noting two large funding rounds for Real’s portfolio firms in the first quarter, including healthtech firm League’s $95-million raise and a US$270-million round for Paper, an online-tutoring firm. 

“There’s a lot of dollars going out, but there’s a slowdown in the number [of deals],” Furlong has observed. The data appears to bear this out. Canadian firms have raised US$5 billion in VC funding since the start of the year, matching the same period last year, according to PitchBook data provided to The Logic. The number of deals, however, has dropped from 478 to 320.

Deals take weeks, not days 

Those rounds that are closing are taking longer. In 2021, “things would get done from term sheet to signed documents in a week,” said Megh Gupta, partner at Loblaw-affiliated Wittington Ventures. Now, the timeframe is trending back toward the norm of four to eight weeks.

Gupta and other VCs with whom The Logic spoke argued that the speed at which deals were being done last year was unhealthy. The slower pace affords both sides more time for due diligence. Steel said he’s started seeing investors include more protections for themselves against possible losses. “We have definitely seen the resurgence of downside protection,” he said, citing as an example multiple liquidation preferences, which guarantee that venture investors will be paid back more than their principal investment even if a company exits at a lower-than-expected valuation. 

OMERS has so far avoided such terms. “We are forcing ourselves to just have hard discussions around valuations. I think it’s a really big mistake to fall into the trap of taking on these kinds of additional features in order to maximize valuation,” Steel said, noting that it can lock in those terms for future rounds.

Investor, founder expectations ‘difficult to bridge’

When venture capitalists and founders meet these days, their expectations differ widely. “You’re seeing some deals where there is that 50 per cent-plus bid-ask spread, which is really difficult to bridge,” said Brahm Klar, general partner at Round13 Capital.

Pennarun, the Tailscale CEO, knows “a bunch of other founders who are not having nearly such good luck” fundraising. He’s heard valuations have dropped roughly by half since January. Typically, a healthy firm would expect to raise its Series B at five times its Series A valuation, he said, but now it can expect that to be two and a half times.

In this environment, companies needing to raise funds but without the cashflow or profitability that would support an increase in their valuation may face a flat or down fundraising round, one in which the company is valued the same or lower than the last time it took investment.

Both investors and entrepreneurs have started to walk away more often from potential deals, some VCs said. Rhino Ventures partner Jay Rhind tells his portfolio companies they should always be raising. Two of the firm’s companies recently tested the waters for later-stage fundraising rounds, he said. While neither needed the money, they wanted to see what opportunities might present themselves. Neither company received a bid. “It’s frankly very different than it was even one quarter ago,” Rhind said.

Unless their hands are forced, investors and companies lack incentive to make deals amid all the uncertainty, said Version One Ventures general partner Boris Wertz. “Right now, it feels like in most of the cases the best strategy is just to wait.”

The pre-IPO market is ‘pretty much dead’

The tech-heavy Nasdaq Composite Index has lost more than a quarter of its value since the start of the year and the S&P/TSX has fallen about nine per cent in the past month. This April “delivered the worst returns for the tech sector in recent memory,” CIBC Capital Markets analyst Stephanie Price wrote in a note last week. With public markets dropping significantly, companies that had been considering an initial public offering have likely paused those plans. The IPO market for Canadian tech firms froze in the first quarter of the year and VC investors expect it to stay that way for at least the rest of 2022. “​​Pre-IPO rounds are pretty much dead,” said Wertz.

“We’ve put any sort of exit transaction on hold,” said Kevin Talbot, managing partner at Relay Ventures. (Relay Ventures is an investor in The Logic.) One profitable and growing Relay portfolio firm, on whose board Talbot sits, had been planning a 2022 IPO. Now, he said, “We’re fine waiting.”

Talbot said the firm’s bankers had advised it to go public in the current market, anyway, given its performance metrics. “Its advice was this is what the market wants to see. But there’s too much volatility for too many reasons,” he said. If they wait, they can “take an even larger company public in the future.”

Some companies that had planned to go public via an IPO may not be breaking even, however, and may require an injection of funds to bridge them to a better time for an IPO. 

However, the data suggests investors have been avoiding this part of the market. Funding for Series D and later stages has fallen to about US$434 million so far this year, compared to nearly US$1.2 billion for the same period last year, according to PitchBook data. 

If later-stage funds redirect more of their money to portfolio companies to fill that gap, they will slow down on follow-on rounds, said Chris Neumann, a partner at Panache Ventures. These funds also calculate their return on investment based on a company’s exit scenario, such as an IPO. “In a situation like this … it’s a lengthier calculation.”

Layoffs and other cost-cutting measures

Companies waiting for better market conditions must make decisions on how to preserve the cash they have and extend their runway. 

One cost-saving strategy is layoffs. So far this year, Bonsai laid off a third of its staff, Goodfood cut its headcount by 70 employees and Thinkific shed about 20 per cent of its workforce. Some VCs who spoke to The Logic expect to see more layoffs, especially from companies with future funding now in question. It may take time for some to get to that point, though, as they burn through cash reserves. “I think it’s more likely to happen in a big way in the next 12 months,” said Klar.

Instead of raising venture capital, more companies may turn to non-dilutive financing such as debt, or take advantage of government initiatives or tax incentives. “If you can lock it in, it’s probably ideal to do so,” said Rhino partner David Hogarth.

Companies looking to cut costs may reconsider their business model, said Wittington’s Gupta. They may decide to sell fewer products, revisit their pricing or scale back plans for future products. “You’re starting to definitely see companies and … boards clamp down and say, ‘Eye on the prize. Let’s focus on the core business.’”

(Don’t) move fast and break things

Investors aren’t as keen on businesses burning so quickly through cash in pursuit of growth that they’ll have to raise again in a year or two, said Klar. “I think that was quite in vogue in 2021 and parts of 2020.”

Wertz points to ultra-fast delivery companies as an example. Lots of startups promising to deliver food or consumer goods in less than 30 minutes are launching services around the world, including in Canada. But they’re businesses that require a lot of capital and have a low gross margin, he said. “Those are obviously in a really tough spot once capital becomes more expensive.” One example: GoPuff, which hit a US$15-billion valuation, has struggled as investors side-eye its cash burn, reported The Information. 

Web3 and other bright spots

Companies in sectors that are getting government support—like life sciences, cleantech and some advanced artificial intelligence—could have an edge in the slower VC market, said Thomas Park, head of BDC Capital’s Deep Tech Venture Fund. “There are several sectors where governments and stakeholders have said, ‘This is something to keep investing in.’”

Interest in Web3—a catch-all term for a decentralized internet based on blockchain technologies, which includes cryptocurrencies and NFTs—remains strong, said Neumann, and he doesn’t expect that to change. Companies in this sector are developing very new technology, so they don’t face the same pressure to show early revenue, he said. Dedicated Web3 and crypto funds also operate with a more speculative investment thesis and on longer timelines.

The Canadian advantage

As investors lose interest in “growth-at-all-costs” strategies, some of the VCs The Logic spoke with believe the Canadian ecosystem is better positioned than markets like Silicon Valley. “Canadian companies … have always been much more focused on unit economics and how they spend their money effectively to get to profitability,” said Bannister. “Traditionally, Canadian entrepreneurs did not have easy access to cash.”