Things I Think I Think - Q4 2023
Last week brought to a close what was certainly one of the most challenging years for startups and venture capital in recent memory. It was an absolute roller coaster that saw the excitement and promise of generative AI and LLMs, the uncertainty of SVB’s collapse (remember that?) and funding challenges for companies of all stages.
We haven’t yet reached the end of the bumpy roads but, as we enter 2024, I believe there’s significant reason for optimism.
So in the spirit of sports columnist Peter King, here are 5 Things I Think I Think - Q4 2023 Edition:
1. We’re (Hopefully) Coming in for a Soft Landing
At the Panache Ventures AGM in November, my partner Prashant Matta shared with our LPs our belief that the U.S. economy would manage to pull off a soft landing. On December 13, the U.S. Federal Reserve left interest rates unchanged and signalled that, with inflation falling faster than expected, the need to leverage interest rate increases as the primary policy lever had reached an end.
"That's us thinking we've done enough," said Federal Reserve Chairman Jerome Powell, adding that rate increases were "not the base case anymore."
While I don’t expect that interest rates will fall significantly in 2024, the signal that we’ve reached “the top” provides the stability and predictability necessary for capital markets to finally start to open back up. Expect that to start with an increase in IPO announcements and flow back through growth and later-stage venture capital.
Q1 will likely still prove challenging for companies trying to raise later-stage rounds, but by Q2 I expect that we’ll begin to see regular announcements of Series B and C funding (albeit at much lower valuations that in 2020-21). Once that happens, the subset of early-stage VCs who have been sitting on their hands for the past year should come back to the table, leading to a healthy level of activity across all stages heading into the second half of 2024.
Dan Primack of Axios Pro Rata recently noted that,
“One of the first things I learned as a young deals reporter was that private markets always follow public markets, although the lag length varies. If everything holds to form, private market activity should accelerate in the coming months; particularly if the Fed cuts rates, thus loosening both lender and LP wallets.”
In his annual new year’s post, Fred Wilson of USV shared that,
“Optimistic capital markets are necessary but not sufficient for a healthy innovation economy. We also need innovation. The good news is we have a lot of that and more is coming in 2024. I have never seen an environment with more innovation in the forty years I have been in the tech sector. It is breathtaking to see.”
So why did I title this section “…(Hopefully)…”? There are two significant wildcards at play that could derail a soft landing: increased geopolitical conflict (namely, an expansion of the current conflicts in Ukraine and the Middle East, or — heaven forbid — a new conflict with China) and this year’s U.S. presidential election. Assuming that the level of geopolitical conflict remains relatively contained, I would expect a strong (but not mind-blowing) Q1 in the Canadian private markets, followed by a notable uptick in Q2 as we head into the summer.
2. Canadian Founders Have Come to Terms with the Market
In my Q3 thoughts, I observed that we were still seeing Canadian founders attempting to fundraise with unrealistic expectations about valuation (in particular, valuation expectations that were higher than what the market was supporting in Silicon Valley and more reflective of 2021-22 market conditions). As of the end of Q4, Canadian founders have broadly come to terms with the new normal.
In the final weeks of 2023, we met with a number of strong founding teams looking for Pre-Seed and Seed valuations that are very much in-line with the deals that are getting done in the U.S. and other markets. Some were first-time founders. Many were repeat founders. Notably, every startup we met with that was looking for an extension or bridge round was aiming for a valuation reflective of the current market (rather than using an inflated 2021-22 valuation as their starting point). That’s a great sign for the new year.
Valuation convergence in Silicon Valley broadly occurred in Q3 2023. Historically, Canada has lagged Silicon Valley by 1-2 quarters when it came to adjusting to market changes. The fact that we saw valuation convergence take place in Q4 — only one quarter later than Silicon Valley — is a big deal (and one that very much speaks to the maturing of Canada’s startup ecosystem).
Similar to optimistic capital markets, valuation alignment between founders and investors is a necessary but not sufficient condition for deals to get done. That said, with so much innovation happening in areas like AI, energy, climate and infrastructure, achieving convergence sets up the conditions for a strong first half of 2024.
3. The Great Shutdown has Begun
Last quarter, I predicted that we would see a lot of startups close their doors in Q4. While the end of 2023 didn’t produce a tsunami of showdowns, we definitely saw the beginning of a prolonged period of startup closures.
Around the world, there are thousands upon thousands of startups who raised their last round of funding during the ZIRP heyday of 2020-2021 but failed to achieve product-market fit. Their founders have done everything within their power to extend their runways as market conditions changed, but the majority of them (as is true with all entrepreneurial endeavors) will ultimately have to shut down. What we saw in Q4 was the first wave of founders reaching this conclusion.
While some founders publicly shared their final chapters, many more have quietly shut down
In “normal” times, many founders who reach the end of their runway are able to manufacture soft landings for their companies (typically technology/asset sales or acqui-hires). But these are not normal times. With the onslaught of AI over the past 18 months, many startups shutting down find themselves with IP that is obsolete and of minimal interest to potential acquirers. Similarly, the hiring market is by far the most favorable for employers that it’s been in more than a decade. Outside of a handful of specialized industries, there simply isn’t any demand for acqui-hires. (The only asset that remains unquestionably in-demand is cash, so we are seeing acquisitions of companies that still have significant balance sheets yet have chosen to pursue an exit long before their runway runs out.)
Overall, I expect that we’ll see relatively few acquisitions over the coming year and the vast majority of startups will be forced to unceremoniously shut their doors. This will undoubtedly include a number of large, formerly high-flying companies, which will provide plenty of fodder for the media. (Cue the inevitable freak out by Canadian media and politicians pointing fingers about the sky falling on the Canadian tech sector).
Each and every one of these shutdowns will be a difficult event for founders, employees and investors. But in the long run, reaching this long-overdue chapter will prove beneficial to the Canadian tech ecosystem (particularly at a time when AI and other technology sectors are beginning to take off). Unlike in previous cycles, when most startups simply couldn’t afford to hire experienced employees, this time around there will be tens of thousands of ambitious, hard-working people rejoining the workforce with a massive amount of startup experience to bring to the table. That’s a good thing.
4. The Calm Before the AI Storm
The drop in AI hype that started in Q3 continued into Q4, as the public became increasingly less enthralled by all things AI. The Open AI fiasco — complete with VCs unashamedly tripping over themselves to publicly curry favor with various players — certainly didn’t help things. But behind the scenes, the AI storm is brewing.
The level of activity, excitement and creativity happening right now in the Bay Area’s AI community is unlike anything I’ve seen in nearly two decades. We’re past the wave of naivety that comes with the initial introduction of a new technology (during which too many startups and investors incorrectly presume that incumbents won’t adopt it themselves), have converged on an initial AI platform “stack”, and are entering the application phase of AI.
That’s not to say that the foundational landscape of AI is set. Quite the contrary: OpenAI’s self-inflicted misadventures provided a significant opening for competitors, as it shined a giant spotlight on the platform risk faced by companies building upon its APIs. Mistral AI, in particular, is taking full advantage of OpenAI’s miscues.
Just don’t expect a wave of AI-first companies to make noise in the first half of 2024.
Building high-value applications — even ones based on AI — takes time. Regardless of the underlying technology, it takes time to talk to users/customers, time to iterate on the go-to-market hypothesis and time to get to product-market fit. It also takes time to navigate complex procurement cycles and regulatory requirements. Right now, there are numerous companies (including a number in Panache’s portfolio 😉) that are quietly building AI-first applications and iterating in closed beta. Many of these won’t see the light of day until late-2024 or even 2025.
But they’re coming.
5. A Tale of Two Startups
The startup landscape in 2024 will broadly consist of two groups of founders (and, by extension, two groups of employees) who have vastly different lived experiences.
Startups that were founded during or prior to the ZIRP heyday of 2020-2021 likely started off fast, with capital easy to come by. They were founded with the tailwinds of an enthusiastic market behind them, only to run head-first into a wall of uncertainty. For companies that manage to survive The Great Shutdown™ but have not yet attained product-market fit, the new year sadly won’t offer a much-needed respite. Instead, they’ll graduate to the next phase of a grueling marathon that not only includes finding product-market fit, but also demands that they hold together an exhausted team that will undoubtedly be inundated by job offers from hot, new startups (which don’t shoulder the same baggage).
For startups founded during or after 2022, capital was never easy to come by (with the exception of certain AI startups). These teams have had to be frugal from the start. The best of this cohort enter 2024 with strong, cohesive teams, a deep focus on customers, product-market fit, and — wait for it — revenue. Not to mention simple, stable balance sheets. As private capital begins to unlock, some of these companies will add rocket fuel to their very strong foundations, leading to a level of acceleration that we haven’t seen since 2010-2011. Many more will question whether traditional VC funding is right for them at all…
But I’ll leave that topic for another day.