The Venture Capital Correction
If you want to understand the state of venture capital this year, look no further than the recent raise extension by Golden Valley-based Omnia Fishing.
In May, the e-commerce company launched a subscription service that offers anglers real-time, location-specific data on water clarity, temperature, and wind speed. Adding these features required funding, and Omnia’s three founders, all of whom have prior startup experience, have made it look easy, raising an initial $1 million to start building their tech-intensive platform in 2018, and more than $8 million to date.
But Omnia CEO Matt Johnson sensed investor appetite was waning. So rather than initiate a new raise, the company went back to current investors this year for an extension on the $4 million funding round it closed in early 2022. When discussing the raise, the CEO used the recent magic buzzword among investors, promising “capital efficiency,” as funders have become more risk-averse to new projects.
After an abnormally hot investment market that caught fire in 2019 and peaked in 2021, business investments have been down across the board this year. Many will attribute the dip to rising interest rates and upsets like the closure of Silicon Valley Bank.
But is it a slump or a market correction? Experts say the year-over-year funding decline seen this year is not an anomaly. More unusual was the enormous wave in investment dollars funneled into businesses from 2019 to early 2022.
The days of growth over profit may be a thing of the past; Omnia’s conservative new approach to fundraising reflects that. Says CEO Johnson, “We’ll operate as if this is the last capital we’ll have access to and take bigger risks, while still being conservative, now that our flywheel has been proven.”
Return to Normalcy
Minnesota companies raised $437 million in the first two quarters of this year, down 63% from the $1.2 billion raised during the same period last year, according to investment tracker PitchBook. Notably, the total number of deals made in that time were about equal. Investments are still being made, but many have been smaller than the record deals seen during the VC boom.
This pattern is in line with national investment trends. In 2022, U.S. private venture-backed companies raised $238.3 billion in venture capital, down from $344.7 billion raised in 2021.
John Stavig, director of the Gary S. Holmes Center for Entrepreneurship at the University of Minnesota Carlson School of Management, calls the current downward trend in business investment dollars a “return to normalcy” after an abnormal few years of inflated investing.
What Stavig is talking about can be seen in the numbers. While Minnesota businesses have raised far less compared to last year, the $437 million raised during the first half of this year is comparable to the $445.9 million raised in the first half of 2019. With a background in management consulting and private equity, Stavig says the most surprising thing about current investment trends is how long it took for funding to normalize.
“It was very entrepreneur-friendly in 2021, early 2022. So much of the capital went toward these later-stage mega-round investments that were somewhat of a different form of venture capital,” he says. “There were more nontraditional hedge funds and other corporate venture money coming in. To some extent, I think the numbers were inflated in terms of how distorted the market was.”
Don’t put all VC in one bucket
Local tech entrepreneur and angel investor Daren Cotter says venture capital is often spoken about as if it all goes into one bucket. This isn’t the case, he notes. There is a big difference between early investments in Series A and earlier rounds compared to later series investments. Total venture capital dollars are down, but Cotter notes that this is largely because there have been fewer later-stage funding rounds closed on. Many investors are still funding seed and pre-seed rounds, but Series B and higher-round closures have fallen, and these make up the minority of deals that usually close on the majority of dollars.
There have also been markedly fewer late-stage funding rounds in the state this year. One of the few that stood out was a $54 million Series D round raised by Minneapolis-based software company Flywheel, a medical imaging platform for research and AI.
Despite securing this raise, Flywheel CEO Jim Olson acknowledged the difficulty of raising VC money this year. “The environment is terrible,” Olson told TCB this summer. “There’s no other word for it. The large growth funds are kind of hitting the pause button. They’re very interested in our overall story and progress. They’re staying in touch but not opening the checkbook.”
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Every investor is different, Cotter notes. “Generally speaking as an investor, my mindset is: I want to invest in companies that, if everything goes right, have the potential to be a very large company,” he says.
“We had guidance from our early investors… not to get too crazy with our early investments and overpromise too much. That puts us in a better position than some.”
—Tom O’Neill, Founder and CEO, Parallax
The denominator effect
Fundraising has become difficult across the board, from startups to venture capital firms looking to raise capital from partners, according to a PitchBook analysis of second quarter 2023.
The ripple effects are numerous: There are almost no initial public offerings happening this year, on top of a massive reduction in mergers and acquisitions, says Vincent Harrison, an analyst with PitchBook. “So not a lot is happening in terms of exits, which is tough for the venture ecosystem because that’s often how returns are realized.”
“The market got really hot and this definitely is a cool-down. I think 2021 was a perfect storm for a number of reasons,” Harrison says.
For one, nontraditional investors in the ecosystem included crossover investors, sovereign wealth funds, and asset managers—all investors who, Harrison notes, are not exclusively investing in venture capital but were inflating reported funding during its peak. What has happened since that time is the “denominator effect,” Harrison says. It can be seen through funders who invest in both public and private assets.
Harrison explains the denominator effect: Say an investor puts $100 million into public and private assets split evenly: $50 million in public and $50 million in private. Public markets are valued daily and posted to the stock exchange for the public to see. That doesn’t happen for private investments. In that case, when investors have assets—say $50 million in public markets and $50 million in private markets—and the value of that private market gets cut in half, it looks like they’re invested 75/25 private to public. But these investors have a mandate to keep that investment at 50/50, and now it looks like they’re overinvested in the private market—so investors pull out of that market.
“So all of that to say, 2021 was very hot,” Harrison says. “You had a lot of those investors who were involved, and then things started to go down and they pulled away. So until those investors come back into the space, it’s going to be hard to replicate the 2021 highs.”
Harrison calls this current period a stabilization and a correction under a new normal. “Just because things have come down doesn’t mean they’re necessarily bad on a historical basis.”
Good news for the thrifty
It’s possible stabilization could benefit Minnesota companies that have tended to be more capital efficient, Stavig notes. Only a small fraction of the nation’s venture capital dollars go to Minnesota businesses.,with the vast majority funneled into California, New York, and Massachusetts companies.
“We really typically don’t have the model here of throwing a lot of capital at a business and hoping that you can dominate a market and grow very quickly,” Stavig says of Minnesota. “I think that that model on the coasts sometimes distorts the market, and certainly did in recent years. Whereas in Minnesota, I think there are a lot more companies that take a leaner approach and raise capital to scale the business as opposed to raising capital early on just to grow and try and dominate a market.”
That leaner approach to investing can be seen in Minneapolis-based software company Parallax’s recent $12 million Series B. Founder and CEO Tom O’Neill tells TCB, “We had guidance from our early investors to not follow that trend … not to get too crazy with our early investments and not try to overpromise too much, and that put us in a better position than some.”
A couple of years ago, when Parallax was raising its Series A round, O’Neill says the market for raising money was much different. Companies were getting fairly high valuations that “were maybe unrealistically high.”
Stavig concurs that high valuations drove investments in those years. Then, when public market pricing went down and the IPO market largely dried up, so did funding in larger, later-stage investments. “In some ways, I think this is a healthy change,” he says. “I mean, it’s challenging, certainly, for startup companies. But I think it’s forced them to conserve capital and push toward a leaner model and a more clear path toward profitability, and less toward pure growth, which I think is a good thing.”
