How the VC market transforms: a new approach to valuations and venture capital cycle
Published: 2022-12-27 13:38:34

The current economic climate sets off major transformations in the VC landscape; investors begin to denounce practices that used to be defining for the industry.

If we compare the approaches that VCs and private equity firms take to financing, we will observe many differences that mainly concern the stage of a company’s growth and the amount of risk involved. Private equity firms primarily invest in mature businesses with a steady cash flow that are already profitable or are likely to start generating profit  and demonstrate positive EBITDA rates in the very short term. They take an interest in companies that are already past their growth stage; it might be the case that the business is in decline or is seeking to scale and win a larger market share. In this case, a PE firm invests in the company with the goal of refining its processes or infrastructure. Any such investment typically comes in at a very sizable amount, resulting in the purchase of a majority share or the entire business. With such a heavy influx of cash and the transfer of decision-making power, any associated risks are brought down to a minimum. 


![Image description](https://dev-to-uploads.s3.amazonaws.com/uploads/articles/ln8b7mmo3mb178nk275r.jpeg)
[source](https://www.hadleycapital.com/insights/small-business-private-equity/private-equity-vs-venture-capital)


VCs, on the contrary, prefer to get involved at very early stages of business and support emerging companies that exhibit potential for substantial growth. At this point, startup founders probably have little to offer aside from a promise of innovation and a persuasive pitch deck. The amount of risk venture capitalists take is much higher, but so is the size of returns when a startup thrives and manages to boost its valuation; at the same time, VCs normally have multiple companies in their active portfolio, thus hedging their bet. Investment in this case gives VCs control over the minority stake in the company, which can amount to as much as 20% in the Series A funding round and expand with any subsequent rounds.

Venture money has never before been brought into play with long-term growth in mind. Essentially, a venture capitalist purchases a stake in the founders’ idea and then fosters it to escalate a business’s value and reap major benefits at the exit, which comes in the form of an IPO or an acquisition. This is especially true of pre-seed and seed investors that are constantly on the outlook of high-quality ideas capable of generating high returns. The valuations that take place at pre-seed and seed rounds are largely arbitrary and based solely on the promise investors see in the company and the confidence they have in the founding team. This lack of any real traction is often the reason why the source of seed money is often FFF money, or money received from family, friends, and "fools"—investors with little or no venture funding experience. At the same time, if a startup manages to secure VC funding so early on, the investors’ strategy would be to maximise its initial valuation with a hundred thousand or even million dollar investment for the chance of major future gains. 

However, today, amidst the economic uncertainty, VCs are adopting a new opposing trend where they take a more scrupulous approach to selecting candidates for investment. It appears that now funds are opting out of offering generous seed round financing and resorting to a safer alternative of long-term benefits, which can be more modest in size but are also guaranteed by a company’s consistent financial performance and impactful projects. Venture capitalists prefer to become involved at later stages, when a business can provide evidence of not just potential but actual success and the founders have demonstrated the ability to use funds efficiently. Such an attitude shift is bound to prompt further transformations in the VC landscape; one of them might concern the entire structure of venture financing as we know it today.


![Image description](https://dev-to-uploads.s3.amazonaws.com/uploads/articles/80jam80dw1edwfvfi5yv.jpeg)
[source](https://www.hadleycapital.com/insights/small-business-private-equity/private-equity-vs-venture-capital)

The traditional fundraising structure involves completing multiple rounds, first raising initial pre-seed and seed capital, followed by Series A, B, and C investments, before a startup company can go public or exit by acquisition. Now, given that VCs are becoming reluctant to back initiatives that only exist as ideas, the first two steps might become redundant, and the financing cycle will begin with a Series A round. At this stage, venture capitalists will be able to thoroughly vet companies by examining their performance trends. Investors will want to see an operational business where they can assess its balance sheet and financial model, gauge returns based on multipliers or time to liquidity, as well as evaluate the team and the relevance of the product. 

These projected transformations mean that emerging companies might experience a harder time attracting their initial financing from venture capital firms. At the same time, established businesses, which have already raised their Series A or B capital or even exited successfully, find themselves in a more secure position where they can use the funds to ride out the so-called “valley of death” and emerge on the other side with a mature project that can then be showcased and pitched to investors.