Things I Think I Think - Q3 2023

With all of the uncertainty of the past couple of years, I’m often asked for my opinion on the state of the venture market, macroeconomic trends and what’s happening in tech both within Canada and abroad. So I thought I’d start sharing my thoughts on a quarterly basis.

I’m definitely not the first person to do this. To that end, here are some recent state-of-the-market posts I think very highly of (go read them!):

And now, in the spirit of sports columnist Peter King, here are 5 Things I Think I Think - Q3 2023 Edition:

 

1. Valuations Have Stabilized, Deal Flow Has Not

Last week, Alex Kolicich of 8VC posted an excellent analysis of the current venture market, arguing that the “new normal looks a lot like the old normal of 2018.” While I think this is true of valuations, from the perspective of deal flow / number of deals being done, we’re not there yet.

In the Bay Area, activity at the Pre-Seed and Seed stages has picked up significantly and we’re starting to see a meaningful number of Series A and B rounds getting done. However, outside of the Bay Area, the rebound hasn’t been as pronounced.

 

The view from New York

 

Many founders I’ve spoken with outside of the Bay Area remain anxious about the willingness of VCs to write checks and are holding off on fundraising. In parallel, some VCs are reticent to make new investments at a time when they’re not seeing very many opportunities. A handful of funds have gone a step further by extending their deployment period (the time frame in which they can invest in new startups), while others have started privately repositioning themselves around the 2024-25 “vintage years”.

 

The perspective in Utah

 

That’s not to say there aren’t any deals being done. In Canada, a number of startups have recently raised substantial rounds in hot sectors, such as AI and climate. There are also quite a few angel rounds taking place across the country. But we’re not seeing close to the same increase in deal flow velocity at the Pre-Seed / Seed / Series A that’s occurring south of the border.

Checking in with a Toronto-based GP 👀

As a result, I expect two things to come out of Q3 and Q4 in Canada:

  1. The aggregate amount of venture dollars invested will go up moderately relative to Q2, primarily driven by a small number of large deals

  2. The total number of deals completed will stay relatively flat (or potentially even decrease) when compared to Q2

Looking further ahead, I expect that we’ll start to see a meaningful pickup in the number of deals starting in Q1 2024, with overall deal flow activity stabilizing by next summer.

 

2. Many Canadian Founders Continue to have Unrealistic Valuation Expectations

In Silicon Valley, the return to pre-pandemic valuation norms is, at this point, well understood and accepted by both investors and founders. This mutual understanding is, in my opinion, one of the key reasons why Pre-Seed and Seed activity has picked up sharply in the Bay Area leading into Q4, whereas we haven’t seen the same rebound in other ecosystems. Investors and founders are broadly on the same page, so deals are getting done.

In Canada, we continue to see founders across the country approaching investors with valuation expectations that are more reflective of 2021-22 market conditions than what’s happening in 2023.

(Note: I fully recognize the conflict-of-interest / self-serving nature of an investor proclaiming that valuations need to go down, but hear me out…)

In general, the valuations of companies that raise funding from Silicon Valley VCs are higher than the valuations of similar companies raising capital anywhere else in the world, due in large part to the globally unique competitive dynamics amongst Bay Area investors. All things equal, companies that raise from U.S. VCs should generally command higher valuations than equivalent companies who raise from non-U.S. VCs (other than competitive situations where a non-U.S. VC “beats” a U.S. VC for a deal).

But in Q3, we regularly met with Canadian founders who were looking for valuations that were significantly higher than what equivalent companies are currently raising from Silicon Valley investors.

Valuation alignment between founders and investors is crucial to deal flow velocity. Obviously, founders will almost always want a higher valuation than what investors might prefer to give, but so long as the gap remains relatively narrow, deals get done. That’s not what I’m seeing in Canada right now. In contrast to Silicon Valley, the valuation gap between Canadian founders and investors is inhibiting deals that would otherwise take place from getting done.

Historically, it’s not unusual for Canada to lag Silicon Valley by a quarter or two when it comes to adjusting to market changes, so my hope is that we’ll see convergence by the end of the year (which would further support a strong level of activity in Q1).

 

3. Q4 Will See a Lot of Startups Shutdown

At the same time we’re beginning to see a resurgence of investments in new startups, we haven’t yet seen the full washout of startups who raised their last round of funding during the ZIRP heyday of 2020-21 but failed to achieve product-market fit.

Giving credit where credit is due, many founders did an incredible job of extending their runways as market conditions changed. Unfortunately, the majority of them (as is true with all entrepreneurial endeavors) will ultimately fail to reach profitability or product-market fit. At this point, there are a large number of startups around the world that are finally reaching the end of their capital and are unlikely to attract new investors.

Some companies, like Clearco, will survive through recapitalizations and down rounds. But at a time where many investors remain hesitant and/or are looking ahead to new opportunities — such as those being created around AI — many more will find their journeys come to an end.

I expect that the next two quarters will see a lot of startups seek out soft landings or close their doors altogether, which will feel rocky for the Canadian startup sector. But in the long (and even medium) term, this will result in a recycling of experienced startup workers into new companies at a time when demand for talent remains high.

 

4. Generative AI is at Peak Hype, Generative AI is Just Getting Started

The first half of 2023 saw generative AI land at the forefront of public consciousness following the release of ChatGPT 3 in late-2022. VCs around the world rushed to make investments into this new generation of AI companies while the public’s imagination went wild. 123 of the companies in YC’s summer batch were AI-related (including Panache portfolio company, Reworkd 😉).

But as Alex Kolicich noted in his recent state of venture market update, web traffic related to generative AI has dropped sharply since the summer and there are widespread reports that ChatGPT’s revenue has similarly slowed, suggesting that the public’s infatuation with gen AI has waned.

From an investment standpoint, VC dollars for core models and infrastructure are coalescing around a relatively small number of companies (with some pretty massive rounds taking place). The initial excitement around agents and other general-purpose AI tools is fading and most investors (Panache included) are looking ahead to vertical-specific applications of AI.

In general, the shift from general-purpose platforms to purpose-built applications takes time, so don’t expect to see many of these in market for several quarters. But investments are taking place and the applications are coming.

 
 
 

5. Generative AI Will Change Startup Trajectories Forever

A lot of people describe the potential impact of generative AI on company-building by comparing it to the shift from on-premise hardware to cloud computing. The emergence of cloud computing massively decreased the cost of bringing a software product to market, as startups no longer needed to buy expensive servers (I still have PTSD from all of the servers we had to build at Aster Data…). The corresponding argument is that generative AI will further decrease the cost of bringing a software product to market, as fewer developers will be needed to achieve the same output.

While that’s certainly true, there’s a second potential impact that could be an absolute game-changer: generative AI has the potential to significantly reduce the length of time it takes to bring a software product to market.

Think about it: while the emergence of the cloud meant that startups no longer needed to buy and provision expensive hardware, it generally did little to reduce the length of time needed to create the software that sat on top of the cloud. (Yes, AWS and its peers over time created a variety of tools to streamline operations, but you still had to write the software).

Already, we’re seeing AI copilots and other generative AI tools improve the efficiency of developers by 3x or more. What happens when instead of measuring the savings in headcount and cost savings, we think about it in terms of development velocity? Can we achieve the same amount of development work in 1/3 of the time? Is it possible that we’ve just upended The Mythical Man-Month?

 

Is this still required reading in school…?

 

To be clear: I don’t expect that generative AI will magically reduce the length of time needed for every task in a startup (e.g. it’s still going to take months for enterprise startups to get through BigCo™’s convoluted procurement process), but I think we’ll absolutely see a decrease in the length of time needed for many software startups to bring initial products to market, achieve product-market fit and generate meaningful revenue.

For self-service and PLG-driven SaaS companies, it’s very likely that we will see a corresponding compacting of time between funding rounds. Conventional wisdom holds that startups generally raise funding every 18-24 months, but I think we’ll start to see a subset of startups raise at shorter intervals and/or “skip” funding rounds, due to their ability to quickly hit key milestones that de-risk the business in a meaningful way.

The Quiet Part Out LoudChris NeumannThings I Think I Think