With public markets spooked over the prospect of rising interest rates, the future looks uncertain
Just a few years ago, a typical early-stage venture funding round netted $1 million, maybe $2 million, for a startup to build out its technology and get it ready for market. So what is one to make of the US$40-million Series A round fundraised by Gandeeva Therapeutics, a tiny biotech firm based out of a lab at UBC, this past January?
As we chat over a Zoom call, Gandeeva CEO Sriram Subramaniam is grinning from ear to ear. A researcher with the National Institutes of Health in Washington, D.C., for 18 years, he regards the past four as a dream come true. It feels like a whirlwind picked him up and dropped him on the shore of the Salish Sea with a mandate—and now the money—to pursue his outlandish idea for cryogenic electron microscopy.
Gandeeva will use the cash to develop its platform, which creates images of proteins and then, with the help of machine learning, models how they might interact with different drugs. Subramaniam had been talking to venture capital firms about it for a few years when UBC stepped up to fund research and take him on as a faculty member in 2018. Not long after he arrived, though, COVID-19 hit and the university mandated that anyone working on the campus had to be fighting the virus. So Subramaniam set about imaging the spike proteins of novel coronavirus variants. He ended up publishing one of the first images of Omicron’s distinctive spike protein, believed to make the variant more transmissible, in the journal Science.
“In order for the company to get off the ground, we needed infrastructure for biochemistry, computing, microscopy. All of this had to be built,” Subramaniam says. In an unexpected way, his team’s forced foray into COVID-19 research not only allowed them to build the platform for Gandeeva but also gave them credibility that the technology they were developing could have potentially lucrative real-world applications.
This time, the venture capitalists were prepared to listen. By the end of 2020, Subramaniam had held substantive discussions with New York–based Lux Capital, an early believer in the potential for imaging as a tool for advancing drug discovery. Just over a year later, Lux led the funding round with participation from two big pharma companies’ own corporate VC funds, Leaps by Bayer and Amgen Ventures—one of several eyebrow-raising sums raised by B.C. firms in 2021 and into 2022. Already, though, the rising threat of inflation had brought a chill down on technology in the public equity markets, leading many to foresee a similar downturn in the VC space.
After the flood-drought?
It’s hard to overstate what a blockbuster year 2021 was, both here in B.C. and across the country. The Canadian Venture Capital Association (CVCA) counted 753 deals collectively worth $15 billion. That compares to $6.2 billion in 2019, the last pre-pandemic year and itself one of the best in the country’s history. In a release, the association said it saw “increased cheque sizes across the ecosystem.”
Forty-two companies, including B.C.-based Trulioo and Dapper Labs, raised more than $100 million. And the 313 seed financings worth $1.1 billion left a “robust pipeline” of early-stage startups that will need follow-on funding sooner or later. At the other end of the venture development cycle, it was also a big year for initial public offerings, with 90 B.C. companies and 171 Canadian ones going public for $2.2 billion and $10.2 billion, respectively, according to data provider CPE Analytics.
Gandeeva Therapeutics raised $40 million in Series A funding, thanks to its pioneering work in precision imaging of protein-drug interactions
It was the same worldwide. Startups around the world raised a record US$621 billion in funding, a 111-percent increase over 2020, according to research firm CB Insights. The number of global unicorns—private, venture-backed firms worth more than US$1 billion—had by February of this year surpassed 1,000.
The good times were a function of two phenomena, explains CVCA board chair and Yaletown Partners co-founder Hans Knapp. One factor was the extreme low interest rates engendered by central banks to avert a COVID-19 recession. The second was the steadily mounting supply of venture money. In 2021, a rising flow of money into tech startups met a fixed number of deals. Investors were willing to buy in at higher valuations. Seed rounds that used to go for $1 million were raising $3 million and more.
But as the calendar turned on 2021, spiking inflation had more and more voices calling for interest rate hikes from central banks. The expectation that overnight rates will rise quickly from their COVID-era floor of 0.25 percent in the U.S. and Canada sent a shiver through equity and bond markets.
The inflation scare has been especially hard on technology stocks. The tech-heavy NASDAQ Composite Index dropped 16 percent between late November and mid-April. Facebook parent Meta Platforms’ stock value was cut nearly in half. And the carnage wasn’t confined to American markets. Since November, when it topped the Toronto Stock Exchange in market capitalization, Ontario’s Shopify has lost more than 60 percent of its value.
A particularly rough week in January prompted some in the venture capital business to predict even greater losses in the private markets. “They’re going to get hammered, especially those companies that are not profitable and will be needing capital soon,” John Ruffolo, a one-time dean of Canada’s venture capitalists when he ran the Ontario Municipal Employees’ Retirement System’s (OMERS) VC fund and now managing partner of Maverix Private Equity, told the Globe and Mail.
“The music has to stop sometime,” agrees Pankaj Agarwal, managing partner of Optimus Information and an angel investor based in Vancouver. It may take months or years to play out, but he predicts that some companies funded at high valuations over the past couple of years will face “down rounds” at lower multiples in the future or run out of money. That will have repercussions: capital losses, broken business relationships, sullied reputations.
“I don’t feel too bad about it. It’s capitalism,” Agarwal says, noting the industry went through the same thing in 2000-01 and 2008-09. “It eventually makes the market better.”
While not quite as gloomy, Yaletown’s Knapp expects that “the valuations that would have been attainable as little as four months ago are now going to be rare or entirely unattainable.” That’s not to say they’re going back to pre-pandemic levels, but there will be some retracement, with seed rounds fetching $2 million to $2.5 million, he says. Also, deal terms that were extraordinarily founder-friendly last year will shift toward investors’ interests.
Winners and losers
“Looking back a month in the rearview mirror, our timing looks good,” says Damir Hot, CEO of Canalyst. The Vancouver-based investment analytics company announced a US$70-million round on January 18, in the midst of the tech correction. Though Canalyst, whose new shareholders include the august Canada Pension Plan Investment Board, may seem to have made its money heist just under the wire, Hot has confidence that the company—and other B.C. startups like it—would have persevered even without the cash infusion at this precise time, whether by accepting a somewhat less lucrative deal or opting not to raise money at all.
Since Canalyst’s founding in 2015, “we’ve never had trouble raising money,” Hot says. Looking forward, “there’s still lots of capital out there for good companies.”
IT companies engaged in “transactional infrastructure” that analyzes and optimizes data relating to commercial transactions, as Canalyst does, will remain popular with investors, Knapp predicts, as will companies with an environmental or energy transition angle. Importantly, companies that get funded will have a “quantifiable story,” he adds. The business proposition will be supported by actual sales growth or other performance metrics.
Maria Pacella, managing partner of Vancouver-based Pender Ventures, the VC arm of PenderFund Capital Management, agrees that data analytics and enterprise software will stay hot. “The data’s still exploding,” she says of the information that organizations of all kinds find themselves collecting as they digitize various aspects of their operations. The prominence of the pandemic and climate change will see a continued appetite for greentech and health sciences ventures, too. Pacella points to a rise in VCs’ use of ESG (environmental, social and governance) criteria, applied not just to startups targeting environmental and social solutions but to all companies seeking funding, as a function of standard due diligence.
But other niches are due for a dressing down, including the consumer-facing or so-called B2B2C business models that saw the greatest run-up in valuations, as high as 20 times annual revenue in 2021, Knapp says.
It’s not just venture capital that has grown exponentially in recent years. A growing number of startups are drawing on venture debt to get their ideas off the ground.
“What you’ve seen is the technology community overall has realized there’s more than one way to fund your company,” says Randy Garg, founder and managing partner of Vancouver based Vistara Growth, whose business spans the boundary between equity and debt investments. Borrowing money instead of giving up equity sounds pretty good to a founder who expects to hit some big milestones in the next year or two and move up to a higher valuation.
But what’s in it for the lender? How safe can it be to lend money to an unprofitable startup with no collateral?
Borrowers typically can offer two things, Garg explains. The first is venture backing that the lender trusts and has confidence in (often the VC and lender are one and the same). The second is the widely adopted software-as-a-service (SaaS) model, which ensures even very young companies a measure of recurring revenues.
“In the old days as a founder, you woke up on January 1 with no revenue on your books,” says Garg, a 28-year veteran of technology investing on the West Coast. “Nowadays, companies start the year with at least 80 percent of last year’s revenues already in place. That predictability is something debt financiers can hang their hat on.”
Any startup worth its salt is likely to end the year booking at least 150 percent of the
previous year’s revenue. So for a venture lender or even a bank to put up money
in return for a claim on, say, 40 percent of the previous year’s receipts no longer looks so risky. And with the still very low cost of capital generally, the interest on those loans will be in the low double or even high single digits—a small price for many founders and seed investors to avoid further dilution.
Why inflation weighs on tech
Understanding the threat posed by inflation and rising interest rates on technology finance means understanding the concept of duration. Any investment is theoretically worth the sum total of the return of capital when it matures or is sold, plus any capital gain and/or income it produces during the holding period, minus a discount reflecting the likelihood things don’t turn out as projected. Long-duration assets such as bonds maturing in more than 10 years, regulated utility stocks and raw, undeveloped land are highly sensitive to rates because that payoff is back-loaded.
That’s even more true of equity in early-stage technology companies. You’re investing now for profits that will only materialize (if at all) five, 10, 20 years from now. So if inflation starts running at 5 percent (as it’s doing now) year after year, that future payoff is worth less and less in today’s dollars. And should risk-free assets like treasury bills and guaranteed investment certificates start paying a higher rate of interest, investors are going to consider reallocating more of their savings in that direction, reducing demand for venture stakes still further.
Investors don’t fear imminent interest rate hikes so much as uncertainty over the medium to long term—whether rates could keep on rising afterward. If so, the discount rate, or present value of future profits, would rise more steeply. “All these high-growth companies that are currently unprofitable, when their future profits become less valuable in today’s dollars, that hits their valuation harder than companies that are already close to break-even,” Knapp says.
“Canalyst is a capital-markets-focused business,” says CEO Hot. “We’re acutely aware of the fact that long-duration assets tend to be more valuable in low interest rate environments.” But Hot, who networks informally with other local tech entrepreneurs over poker games, tennis and WhatsApp groups, doesn’t consider the VC financings at peak valuations last year money ill spent. “Of the big rounds announced by Vancouver companies, I wouldn’t put them in bubble territory,” he says. “Those are good businesses.”
It’s (a little) different this time
There are factors working against a wholesale retreat of venture finance, especially in B.C. The proliferation of anchor companies like Clio, Dapper Labs, Galvanize and Trulioo has increasingly put the province on the map of technology finance, says Randy Garg, founder and managing partner of Vancouver venture and growth financier Vistara Growth and a 28-year veteran of the local VC scene. The province is also broadly represented with champions and specialized investors not just in information technology but also in cleantech, alternative energy and biotech.
One legacy of the 2021 VC boom is that several startups, now flush with cash, are in a position to make strategic acquisitions themselves to accelerate their technology development and fortify their market position. Vancouver identity verification company Trulioo announced a deal in February to buy Danish software developer Hello-Flow ApS, reportedly for more than US$50 million, after itself raising an eye-watering US$394 million last June. Other venture-backed B.C. companies to make acquisitions in recent months include Certn, Clio and SemiosBio Technologies.
And while valuations may come down, there are good reasons VC won’t go all the way back to pre-pandemic levels. For one, there are ever more technology founders and early investors with significant sums in their bank accounts following premium-priced exits, Pacella says. According to data company Pitchbook, “there’s US$220 billion that has to go somewhere,” she says.
Inflation has affected startups’ capital needs, too, Garg notes. “The $1 million that used to get you eight engineers now might get you four, so your costs have gone up dramatically,” he says. So they need to raise more money than they used to.
Also, venture capital has become an essential asset class, both for governments looking to develop their economies and investors starved for growth in the mainstream stock-and-bond markets. “These days, everyone’s a VC,” Pacella says, among them pension funds, sovereign wealth funds, corporations and hedge funds. There is a risk that some of these newer entrants to the marketplace could get spooked by this year’s pullback and vacate the space, but she doubts it. “Twenty to 30 percent growth is impossible to find in the public markets.”
As for the inflation threat, it’s worth noting that the VC ecosystem as we know it found its feet in the 1970s and ’80s, a time of astronomically high inflation and interest rates by today’s standards. (Before that, most innovation was bootstrapped or spun out fully formed from big-business “skunkworks” and government or university labs.)
Investors new to the venture space have to understand that it’s not a liquid, quarter-to-quarter performer, though. It can be a multi-decade commitment. In a blog post last fall, Pacella recounted the 17-year journey of Burnaby-based Teradici Corp., a portfolio company under her purview both at Pender and earlier in her career at the Working Opportunity Fund, to its acquisition by HP last year. Teradici worked on some of the “hard” technologies for remote server access that went into making working from home seamless and the entertainment streaming services we take for granted possible. For the company’s investors, the pandemic furnished a golden opportunity to go out on top, but only after an excruciatingly long wait.
“I feel fortunate to have the money in the bank and to have the runway to actually do the things we set out to do,” Gandeeva CEO Subramaniam says. More than just a cyclical tech downturn, he faced the greater challenge of translating basic research into something commercial interests could get behind. UBC’s leap of faith in his work was key to getting the infrastructure set up and attracting the attention of VCs and pharmaceutical companies, he says.
“Vancouver is a place where things can happen,” Subramaniam adds, sounding more like a tub-thumping booster than a recent arrival. “What if this is the new Silicon Valley? Why don’t we have that mindset? I wish there was more of this thinking.”