After two years of the private markets spraying money into backing startups like it’s champagne, the industry is feeling the hangover.
To help startups prepare for what’s next, we surveyed venture capitalists from over a dozen firms, including Accel, Index Ventures, Insight Partners, IVP, Lightspeed, New Enterprise Associates, and Sequoia, to share their predictions for the new year.
We asked them to reveal the hot sectors they’re eyeing, the trends that will fizzle, and the new realities of fundraising — for both startups and venture fund managers — in a tech downturn. The bottom line: business won’t be returning to normal in 2023.
Additional reporting by April Joyner.
For a decade, early-stage startups trended away from raising money from a few large investors in favor of cobbling together a big roster of small checks — what’s known as a “party round.” Without a lead investor negotiating, the founder often sets the terms of the deal.
But the party round may soon disappear. “Those rounds are getting more scrutiny these days,” Jenny Fielding, a cofounder and general partner at The Fund, said. “All investors are raising an eyebrow on these party rounds, especially where the price is high. In our case, even with a small check, we’ve been able price a few rounds where we would not have had this opportunity previously.”
The change could be good for founders, Trina Van Pelt, the managing director and vice president at Intel Capital, said. “Now more than ever, it’s critical that companies are very thoughtful to balance depth in dollars and experience on the cap table,” she said.
Generative AI will continue to be the buzzword on every investor’s lips. The term refers to artificial intelligence that can create content, and in recent months, startups have applied this foundational tech to practical-use cases like writing code and editing photos and videos.
“We are now accelerating into the golden age of AI,” George Mathew, the managing director of Insight Partners, said. In the near future, more startups will inject deep-learning software into their programs to supercharge the way we work and try to help people be more productive.
“It’ll no longer be about who is best at pushing pixels on a screen or writing lines of tedious code,” Sonya Huang, a partner at Sequoia Capital, said. “Rather, the lower-level cognitive work will get automated away, and value will accrue to workers who are able to think creatively and prompt these machines cleverly.”
As a result, “we will see a new generation of enterprise applications emerge to challenge established vendors in almost all categories of software,” Villi Iltchev, partner at Two Sigma Ventures, said.
“Gen Z social is taking off and the next iconic consumer app after TikTok and Snap is being born right now,” Ann Bordetsky, a former Twitter executive and a partner at New Enterprise Associates, said.
She said the conditions are just right for takeoff. Gen Z has rebuked the social networks they grew up on. Incumbents like Meta and Twitter are bleeding talent who may go on to create their own consumer apps. And the surge of artificial intelligence enables the next cohort of consumer companies to get creative with entirely new experiences.
In a punishing macro environment, many startups struggled to raise funding last year as venture capitalists tightened the money spigot.
“The venture market will get worse before it gets better,” Bordetsky said.
While VC firms and investors have stashed away $290 billion in dry powder, according to PitchBook, investors will spend that cash more judiciously as market conditions sour, Jeremiah Gordon, a general counsel and the chief compliance officer at CapitalG, said.
Investors will take a closer look at companys’ gross margins and capital efficiency before writing a growth-stage check, Mark Fiorentino, a partner at Index Ventures, said. Higher scrutiny means funding deals take longer to close, even at the early stage, Katelin Holloway, a founding partner at Seven Seven Six, added.
“Entrepreneurs will need to answer to new criteria to prove their company’s value in a turbulent market, and VCs must ensure their investment will see a return,” Mike Carpenter, a seasoned enterprise executive and venture advisor at Lightspeed, said.
Elon Musk has told Twitter staff they will no longer be allowed to work remotely, and he won’t be the only one making that call. Snap also told employees to expect to work in the office at least four days a week in the new year.
“I am incredibly bullish on a continued pendulum shift back toward in-person work,” Alexa von Tobel, a managing partner and founder at Inspired Capital, said. “Many companies are in survival mode and that often means pulling the team in, setting up a war room, and building together to increase odds of success.”
To be sure, few companies will require employees to badge in five days a week, Lauren Illovsky, a talent partner at CapitalG, said. But they will use in-person gatherings to foster creativity and fun.
“While I don’t think that everyone will be 100% back in the office,” Arif Janmohamed, a partner at Lightspeed, said. “I do believe that we will continue to see increased times where people are together, whether it’s two to three days in the office or quarterly get-togethers to build culture, strengthen relationships, and get stuff done.”
The pandemic shift to remote work made productivity and collaboration tools essential. But in a tech downturn, many business customers are looking to cut spending, and investors say some tools from smaller, newer companies are likely on the chopping block.
The new reality swings the advantage back to major suites like Microsoft and Google while the challengers scramble to adapt.
“Our work life is going to become a battleground for products that want to own more of our working life than just the one, two things they’ve been doing for us already,” Kyle Harrison, a general partner at Contrary Capital, said. “In the future, more platforms will start to overlap — whether it’s Microsoft adding functionality to compete with Canva and Calendly, or it’s Notion starting to get more aggressive in the number of things they’re trying to do for you.”
Derek Zanutto, a general partner at CapitalG, expects full-service apps to win out over software built for specific use cases. “In the past five to 10 years, startups fueled by ample supplies of investment capital rushed to address the pain points that arose from companies’ digital transformation and cloud journeys,” Zanutto said. “Facing a more challenging budgetary environment in 2023, fewer enterprises will be willing to invest in these sprawling point solutions.”
Von Tobel expects businesses supporting remote work, specifically international expansion, to feel the crunch, too. They “will likely see some headwinds as remote work falls out of favor and the current geopolitical climate leads to de-globalization,” von Tobel said.
For a decade, an abundance of capital has motivated more venture capitalists to split from established firms and raise their own funds. In a downturn, their investors — the ultrawealthy, foundations, and pension funds that front money to venture funds — will be “increasingly reluctant” to back individuals raising a first or second fund, Harrison said. He predicts “dramatically fewer first-time funds” launch in 2023.
Other emerging fund managers will struggle to close capital for follow-on funds. That could lead some small-check investors to join forces, Lily Lyman, a general partner at Underscore VC, said. “Venture will consolidate. There will be a wave of solo GPs and micro funds that can’t raise a next fund and will either merge or go back to operating.”
There was a time in the past decade when a startup reaching a value of $1 billion was so rare it was called a unicorn company. But unicorns got a lot easier to find in a bull market that created 340 new unicorns in 2021 alone.
Venture capitalists said that the $1 billion valuation mark will come back as a meaningful metric this year as funding for more mature startups dries up and investors adjust prices based on real data and not vision.
“We’re going to see unicorns become a really big deal again,” Latif Peracha, a general partner at M13 who invests at the early stage, said. “It will reemerge as a massive milestone in the VC landscape.”
“The past two years have been an anomaly and we will see a return to valuations and multiples that resemble the long-term multiples pre-2020,” Cack Wilhelm, a general partner at IVP, said.
Founders will be thankful for the correction in the long run, Huang said. “It’s worth taking a step back and making sure you don’t get over your skis. Remember that the valuation you raise at today sets the watermark for what revenue progress you need to show on the next raise,” she said.
For a while, investors largely avoided vertical software — software tailored to specific industries — because they felt their markets might be too small to make the economics of vertical software viable, Kyra Durko, a principal partner at Two Sigma Ventures, said. That’s now changing in a downturn as investors like Two Sigma and Index Ventures eye companies whose products are mission-critical for their customers.
The golden era of vertical software will “modernize every corner of our economy,” from insurance to bodegas to hair salons, Durko said.
The back office is another area ripe for disruption, Ajay Vashee, a general partner at IVP, said.
“Over the past decade, we’ve seen a wave of innovation transform customer-facing verticals like design, marketing and sales — championed by then-upstarts like Figma, Adobe and Salesforce,” he said. “For the first time, I’m seeing a similar concentration of talent and energy focused on disrupting the finance and HR verticals.”
After two years of startups scaling and burning cash at a dizzying rate, “be ready for a phase of consolidation and wind-downs in 2023,” Payal Agrawal Divakaran, a partner at .406 Ventures who invests in digital health, said.
John Tough, a managing partner at Energize Ventures and climate-tech investor, said he expects merger and acquisition activity to accelerate.
“With a pending economic slowdown, the leading companies in a given sector will become destinations for struggling startups that still have strong intellectual property or customer contracts to offer,” Tough said. “Companies with capital and ambition will be rewarded with opportunities for strategic roll-ups.”
The mental-and-behavioral healthtech category may see a lot of dealmaking, Agrawal Divakaran said. The funding frenzy of the past two years pumped money into startups that “don’t have substantive value propositions, patient-acquisition strategies, or defensible economic models.”
More investors are eyeing a burgeoning tech ecosystem in the Middle East and North Africa. In recent months, venture firms like Lightspeed, Index Ventures, and 500 Global, formerly known as 500 Startups, hired local partners to scour the region for opportunities. And the startup accelerator Y Combinator included 32 companies from Africa across the last two cohorts, a 28% increase compared to 2021.
“While there are many stereotypes to overcome, the region is very forward-looking (trying to figure out post-oil economic engines) and has amazing tech talent, so we expect a lot of innovation from Dubai, Riyadh, and Cairo,” SC Moatti, a founding managing partner at Mighty Capital, said.
Some of the largest and most-respected venture firms are starting to look less and less like venture firms. They’re investing in crypto, buying stakes in publicly held tech companies, and even managing their own founders’ wealth. In 2023, top venture firms will borrow from private equity’s playbook and launch an initial public offering.
“We’ll see venture firms going public as they look to access other sources of capital,” Nigel Morris, a cofounder of Capital One and a managing partner at QED Investors, said.
It’s worth noting that SuRo Capital, a venture firm investing in high-growth, privately-held companies that went public in 2011, is trading down by about 70% since the start of 2022.
For years, startups leaned into “product-led growth,” a method that refers to companies putting out their products and services for free to drive customer acquisition and retention. That strategy is starting to show its cracks in an economic slowdown, Graham Brooks, a partner at .406 Ventures on the data and cloud team, said.
“True PLG is harder and rarer than most people believe,” Brooks said. For it to work, companies must have easy-to-reach users, a hyper-intuitive user experience, and a well-defined “wow” factor that comes early in the product usage. Even when companies meet all of those conditions, Brooks said, they might struggle to convert free users into enterprise customers as businesses look to control costs.
Early in the pandemic, consumer-finance apps were all the rage. Now as publicly held fintech stocks tumble and a recession looms, startups that help other businesses generate revenue faster and more efficiently will pull ahead in usage and venture investment.
“Everyone will realize that B2B fintech is where it’s at as consumer-fintech companies take it on the chin,” Chris Gardner, a partner at Underscore VC, said.
The economic fear and uncertainty bodes well for companies whose software provides earned-wage access, business-to-business payments, and tools for the finance suite, Morris said.
The payments space will be especially interesting to watch as the Federal Reserve rolls out FedNow, an instant-payment service, in 2023, Charles Birnbaum, a partner at Bessemer Venture Partners, said. “All eyes will be on opportunities around faster payments.”
Layoffs sent thousands of big-tech workers from Amazon and Twitter back to the job market during the tech downturn. In time, early-stage startups will snatch up those jobseekers from incumbent companies, investors said.
“With the bitter also comes the sweet. Layoffs across big tech can be a boon for the early-stage landscape in the long run,” Max Gazor, a general partner at CRV, said. “The exodus may burst open a pipeline of determined workers who will infuse seed and Series A companies with the talent they had trouble unlocking during the bull market.”
Investors said new startups will bloom from the carnage at Twitter, Meta, and Amazon. “This time next year I really think that instead of reading news of mass layoffs, we’ll be hearing about all the cool ideas big-tech alum have introduced into the larger startup ecosystem,” Holloway said.
The next wave of innovation in cybersecurity will arrive as more enterprises rush to the cloud.
“While most other enterprise budgets are tightening, security spend will largely be resilient to scrutiny, especially for cloud,” Erin Price-Wright, a partner at Index Ventures, said.
The economic slowdown and shift to remote work has incentivized more companies to replace their existing tech stacks with modern software, Casey Aylward, a partner at Accel, said. The shift creates opportunities for security-focused startups. “There is more desire to ‘buy’ versus ‘build’ when resources are constrained,” she said.
It won’t happen overnight, but startups figuring out how to reduce emissions today will help mitigate the challenges the climate crisis poses.
“From orchestrating distributed electric grids to applying advancements in AI to optimize green-energy usage and production, startups will play a big part in helping us solve the climate crisis,” Vinay Iyengar, a principal partner at Two Sigma Ventures, said.
“Climate-technology focused on reducing greenhouse gasses is imperative,” Tess Hatch, a partner at Bessemer Venture Partners, said. “In 2023, we will see an increased focus on methane emissions thanks to regulatory tailwinds like Biden’s methane plan.”