In review: venture capital in USA

All questions

Overview

US venture capital (VC) experienced a significant retrenchment in 2022 that deepened in the first half of 2023. This retrenchment was primarily driven by steep and continued increases in interest rates, valuation mismatches, the banking crisis, large public tech companies pivoting from a growth focus to an efficiency and profitability focus, and a lack of exit opportunities. According to PitchBook, at all VC stages in the United States, start-ups raised a total of US$87.8 billion (US$175.6 billion annualised) across 8,217 (16,434 annualised) financings in the first half of 2023, compared to a total of US$535.8 billion across 63,514 financings in 2022, representing a decrease of 67 per cent in funding raised on an annualised basis.² Pitchbook projects that 2023 venture funding will be at its lowest level since 2017.³ VC firms, especially emerging fund managers, are also having an extremely difficult time raising funding. In the first half of 2023, 197 US-based venture funds raised only US$27.6 billion, which represents less than 16 per cent of all capital raised in 2022.⁴ In the first quarter of 2023, established fund managers received 85 per cent of the venture capital raised.⁵ One of the bright spots for venture-backed companies is the excitement around artificial intelligence,⁶ which was set off by OpenAI’s November 2022 release of ChatGPT, an artificial intelligence (AI) chatbot, and Microsoft’s inclusion of the technology in all of its products.⁷ In January 2023, Microsoft announced a US$10 billion investment in ChatGPT.⁸

Year in review

Despite a resilient overall US economy and low unemployment figures,⁹ the continued push by the Federal Reserve to increase interest rates eventually resulted in investor wariness and demand for lower valuations for start-ups at all stages.¹⁰ Among other factors, a mismatch in valuation expectations between investors and start-ups eventually led to investors reserving capital and building up dry powder and start-ups pushing out fundraisings. Many start-ups that raised at frothy 2020 and 2021 valuations avoided raising in 2022 and 2023 to avoid the stigma of a down round (i.e., a financing round where the purchase price per share is less than the price in the prior round).¹¹ Many start-ups depleted their cash reserves and were unable to raise in this environment. Some prominent Silicon Valley venture capitalists are predicting a significant increase in start-up failures in 2023. Tom Loverro from IVP tweeted that a ‘mass extinction event’ would hit early and mid-stage companies in 2023 and 2024.¹²

While the tech sector was in turmoil, a US banking crisis was kicked off by the Federal Deposit Insurance Corporation’s (FDIC) sudden closure of Silicon Valley Bank (SVB),¹³ which was the 16th-largest US bank based on assets prior to its closure.¹⁴ The closure of SVB was the second-largest bank failure in US history and the largest since the Great Recession.¹⁵ Two days after the FDIC closed SVB, the regulator closed Signature Bank, resulting in the third-largest bank failure in US history. Failure of SVB was particularly hard for start-up companies because SVB focused on offering debt financing to venture-backed start-ups, founders and venture capitalists.¹⁶ Signature Bank’s customer base also included start-ups, founders and risky cryptocurrency customers.¹⁷ The initial concerns of missing payroll and losing funds deposits in the bank abated when US federal government stepped in to guarantee all deposits.¹⁸ The fallout resulted in a tight debt market and limited borrowing options for start-ups, which are typically considered high risk debtors.

Increased interest rates and low share prices led many large public tech companies to pivot from their growth focus to an efficiency and profitability focus. In the fourth quarter of 2022, many of these public tech companies embarked on cost cutting measures, which included significant layoffs.¹⁹ The shifting public market mentality, dwindling cash reserves and a lack of debt financing options resulted in private tech companies focusing on profitability and reducing their burn rates by, among other things, conducting layoffs. In 2022, 1,058 tech companies laid off 164,709 employees, and the layoffs continued in the first half of 2023 with 839 tech companies laying off 216,328 employees.²⁰

From a cultural perspective, the covid-19 pandemic resulted in a shift in both the location of workers and start-ups and workplace culture. Many workers and start-ups moved from high cost tech hubs, such as Silicon Valley, San Francisco and New York and relocated to lower cost tech hubs, such as Austin, Texas; Nashville, Tennessee; Boulder, Colorado; Boise, Idaho and other locations. The displacement in workers also resulted in many companies struggling with how to manage and integrate remote work forces from a cultural, legal, taxation and technological perspective. In the first half of 2023, there was a big push from some of the larger tech companies to force workers to return to office for a certain number of days per week. Since many workers are not back in the office five days a week, many tech employers have been reducing their office space and requiring workers to share desk space on set weekdays. CBRE estimates that San Francisco had a 32 per cent office vacancy rate for the second quarter of 2023 (compared to less than 5 per cent pre-pandemic in the first quarter of 2020) and that more office space was vacated than newly leased during the same time period.²¹

Another major development has been the continued and intensified regulatory scrutiny of the tech sector. Multiple government regulatory agencies have been focused on the cryptocurrency industry.²² Their focus has not been limited to a certain type of digital asset or service offerings and includes many different types of market participants. The Securities and Exchange Commission (SEC) crackdown has impacted fungible token,²³ nonfungible tokens (NFTs),²⁴ stable coins,²⁵ token issuers,²⁶ staking operations,²⁷ crypto lending operations²⁸ and cryptocurrency trading platforms.²⁹ In January 2023, the White House issued a statement regarding the risks related to cryptocurrency, expressing the administration’s desire to use regulators to mitigate those risks.³⁰ In February 2023, the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency (OCC) released a joint statement warning banking organisations about liquidity risks posed by stable coins.³¹ The Commodity Futures Trading Commission (CFTC) filed over 50 enforcement actions related to cryptocurrency since 2015 and has messaged its intent to increase enforcement activities.³² In March 2023, the CFTC filed a civil enforcement action against the largest cryptocurrency trading platform and its CEO, alleging violations of the Commodity Exchange Act and CFTC regulations.³³ As the regulatory intensity heats up, some cryptocurrency companies have attempted to abandon US operations in search of more friendly regulatory environments.³⁴

The US Department of Justice and the Federal Trade Commission (FTC) have launched extensive investigations of technology companies for antitrust violations.³⁵ Even small acquisitions by large technology companies have come under antitrust scrutiny because the FTC considers the aggregate impact of serial acquisitions to have the potential to be anti-competitive.³⁶ The increased scrutiny of smaller acquisitions has resulted in fewer overall strategic acquisitions by large tech acquirers, thereby reducing overall start-up exits.

There is also a bipartisan effort underway on the federal level to pass privacy legislation to penalise technology and social media companies for improper use of personal data, especially with respect to use of children’s personal data.³⁷ In addition to the US federal government, many of the states have been increasingly focused on passing new privacy regulations to govern how companies collect, store and manage personal data and interact with their customers.³⁸ New privacy regulations in California, Virginia, Colorado, Connecticut and Utah take effect in 2023.³⁹ Many tech companies are being forced to update privacy policies and allow customers to opt out of data collection. These changes make it more difficult for technology companies to use targeted online advertising and email marketing campaigns.

The US federal government is also scrutinising the content posted on the platforms of large social media companies. Congress has formed a special committee to investigate how the federal government may have influenced content on platforms of several large social media companies in a manner that may have violated free speech.⁴⁰ The special committee’s investigation is focused on how the current administration and certain regulatory agencies may have worked with large social media companies to moderate online content in a manner that censored views of the opposing political party.⁴¹ The outcome of this investigation and any resultant penalties imposed on social media companies could have a significant impact on their ability to combat disinformation and result in increased cost and risk related to content moderation.

Legal framework for fund formation

i Structure and formation considerations

VC funds, like most private equity funds, are typically structured as limited partnerships. It is not uncommon, however, for some VC funds to be organised as limited liability companies. In most cases, there is no legal or other substantive difference between the two kinds of structures. It is inertia, the preponderance of precedents and general market practice that leads to most VC funds being structured as limited partnerships.

A typical VC fund will have three entities listed on its structure chart. The first is the fund itself, which is likely to be a limited partnership as noted above. The fund is the vehicle in which each investor will be admitted as a limited partner (or member if the fund is a limited liability company). The fund receives investor funds and makes investments on their behalf. After the disposition of investments, the fund will distribute profits to investors and allocate and distribute carried interest to the general partner. The general partner of the fund (or manager in the case of a fund that is a limited liability company) is the main entity responsible for controlling and managing the fund. The general partner is charged with carrying out the fund’s investment program and causing the fund to act as authorised by its constituent documents. The limited partners have little or no control over the decision-making of the fund except for in certain specified and limited circumstances. However, in most cases, the general partner of the fund, while being empowered to control the fund and cause it to carry out its purpose, is only a shell vehicle that receives and distributes carried interest payments from the fund to carried interest recipients. All actual authority and decision-making is delegated by the general partner to the third entity in the VC fund structure chart, the management company.

It is common, if not ubiquitous, for VC funds to also include a separate management company entity. The general partner of the fund will delegate its authority and power to the management company in exchange for the management company being assigned the right to receive the management fees paid by the fund to the general partner. Neither the fund nor the general partner will have any staff or employees. It is the management company that directly hires personnel to work on behalf of the fund.

ii Brief regulatory overview

For regulatory purposes, the management company entity is considered the investment adviser to the fund, and the fund its client. An investment adviser is an individual or company that is paid for providing advice about securities to their clients. In the United States, investment advisers are regulated both by state regulators, based on the location of the investment adviser’s principal place of business and office, as well as the SEC. Investment advisers with assets under management under US$25 million will typically look to the state in which its principal place of business and office is located. Unless a valid exemption from registration exists in such a state, the investment adviser is required to register with the state securities regulator. Investment advisers with assets under management of more than US$25 million, if they are exempt from registration with the state, must also look to the SEC to see if an exemption is available to the investment adviser under federal securities laws. If no such exemption from registration exists, the investment adviser must register with the SEC. If, however, an investment adviser is registered with the state regulator, it need not register with the SEC until it reaches US$110 million of assets under management, unless an exemption from SEC registration exists for the adviser.

VC funds in the United States are typically private funds that offer their interests to potential investors in private offerings without general solicitation or general advertisement of the public by relying on Rule 506(b) of Regulation D (Reg D) promulgated by the SEC under the Securities Act of 1933, as amended (the Securities Act). This allows them to avoid the onerous requirements of registration of the securities on offer and registration of the fund as an investment company with the SEC. Both outcomes would be undesirable for VC fund managers. A private offering without general solicitation or general advertisings means that a substantive pre-existing relationship is required between the prospective target investor and the fund or its marketer.

Fund agreements

VC funds, just like private equity funds, continue to be ruled by the typical 2/20 arrangement with respect to management fees and carried interest, respectively (i.e., 2 per cent of committed capital of the fund is charged as management fees annually and 20 per cent of all profits of the fund—after investor capital has been returned—is received by the general partner). Unlike private equity funds, venture capital funds generally have greater leeway from investors and market participants to stray from the 2/20 standard and charge both higher management fee and higher carried interest percentages. However, venture capital funds can expect to face pushback, especially from larger institutional investors, if their proposed fees and economic arrangements are seen as too aggressive.

Along with economic terms, other fund agreement terms that are typically negotiated by investors include terms related to the governance of the fund, side letters and access to deal flow information. Governance terms that are typically contested include ability to remove the general partner or manager of the fund without cause by a vote of the limited partners of the fund, prior approval of transactions the fund enters into with affiliates, ability to appoint a voting representative on the advisory board of the fund and restrictions on the ability of the general partner to make unilateral amendments to the fund documents. Side letters are agreements that are negotiated between the fund manager and each investor individually. The side letter is intended to give rights and benefits only to the investor that enters into the agreement with the fund manager. Some managers may also provide ‘most favoured nation’ rights to certain investors in their side letters. Most favoured nation provisions allow for investors that receive them to also elect the benefit of side letters provided to other investors, with certain varying exceptions and limitations. Side letter terms vary widely depending on the unique needs of each investor but typical side letter terms involve better economic terms, more favourable reporting provisions, greater access to the fund’s confidential information and considerations and accommodations for the investor’s unique legal, regulatory or policy situations.

Fund management

Fund managers are required to comply with SEC and state regulations for investment advisers, as noted above. These may include, depending on the size of the funds managed by a fund manager and the fund manager’s reliance on exemptions from registration with either the SEC or the relevant state regulator, appointing or hiring a chief compliance officer, instituting a compliance manual that complies with SEC regulations for registered investment advisers and making annual filings to the SEC and state regulators on the Form ADV.

Typical fund documents include various elements related to fund management. Fund managers may be required to provide audited and unaudited financial statements to investors after the end of each quarter and after the end of the fiscal year. Side letter agreements with investors often include further obligations. For example, many institutional investors require managers to provide additional reporting and information on the fund’s investments, due diligence of potential investments and other information about sourcing and deal pipeline. One other ongoing management area that fund managers may need to pay attention to are conflicts of interests. Depending on the requirements of the fund documents, conflicts of interest may need to be disclosed to investors and, in certain cases, investors consent may need to be sought before any transaction involving a material conflict of interest can be consummated. State and SEC regulations will also need to be followed regarding any material conflicts of interests.

Raising capital by start-ups

Common stock is typically not used for fundraising purposes for US start-ups, in part due to taxation and equity compensation considerations. Most start-ups are cash constrained and, as a result, use common stock as a significant component of compensation in the form of stock options. Deferred compensation rules under Internal Revenue Code Section 409A impose tax penalties on stock options granted at an exercise price less than the fair market value of the company’s common stock on the grant date. In determining the common stock value for purposes of granting stock options, companies typically engage independent third-party advisors so that they can rely on a Section 409A safe harbour. Third -party advisors will typically value the common stock at a substantial discount to the company’s preferred stock due to various considerations, such as the additional economic, governance and other contractual preferences provided to holders of preferred stock. However, sales of common stock directly to investors would be considered in the valuation review and would likely drive up the value of the common stock as determined by third-party advisors, thereby decreasing the compensatory value of such company’s stock option grants. Therefore, most start-ups raise capital in the United States through the sale, or expected sale, of preferred stock at all stages.

The earliest stage of investment is often called a ‘friends and family’ round; however, that reference is slightly misleading, as US securities law will only permit investments in start-ups that are not registered with the Securities and Exchange Commission by persons who qualify as accredited investors, pursuant to Rule 501⁴² of Regulation D promulgated under the Securities Act of 1933, as amended (the Securities Act), which includes:

1. any natural person whose individual net worth, or joint net worth with such person’s spouse, is in excess of US$1,000,000 (excluding such person’s primary residence);
2. any natural person who had an individual income in excess of US$200,000 in each of the two most recent years (or joint income with such person’s spouse of US$300,000) and has a reasonable expectation of reaching the same income level in the current year;
3. any director, executive officer or general partner of the issuer of the securities being offered or sold;
4. any investment adviser registered pursuant to Section 203 of the Investment Advisers Act of 1940 or registered pursuant to the laws of a state;
5. any investment company registered under the Investment Company Act of 1940; and
6. any entity in which all the equity owners are accredited investors.

Early stage and seed stages start-ups will often raise money from angel investors and early-stage funds through simple agreements for future equity (SAFE) financings and convertible note documentation. SAFEs and convertible notes both contemplate that the investor will provide the company with funding in exchange for an instrument that will eventually convert into the preferred stock based on a discount to the future price of the preferred stock or a valuation cap, or both, agreed upon at the time of issuance. Convertible notes vary substantially from deal to deal and are usually more heavily negotiated than the SAFE. A standard feature of the convertible note is that the investor holding the note can demand their principal back if a qualified financing has not occurred prior to the agreed upon maturity date. The SAFE instrument was created by Y Combinator⁴³ to be a simple to use form with minimal negotiation. Unlike a convertible note, it does not accrue interest nor does it have a maturity date.

After initial early stage financings, most rounds are ‘fixed price rounds’ in which the investors purchase preferred stock of the company for a set purchase price. Most fixed priced rounds are made on a standard set of documentation created by the National Venture Capital Association (NVCA),⁴⁴ which limits the amount of negotiation by including standard terms. The NVCA model documents assume an investment in a Delaware corporation and include a Delaware certificate of incorporation, a preferred stock purchase agreement and three stockholder agreements (i.e., a voting agreement, investor rights agreement and right of first refusal and co-sale agreement).

i The NVCA Preferred Stock Purchase Agreement

The NVCA Preferred Stock Purchase Agreement (SPA) sets forth the mechanics and key terms of the financing itself, such as the title of the preferred stock being purchased, the purchase price, closing date and the conditions for closing the financing. Exhibit A to the SPA sets forth the investors and their respective investment amounts. The SPA also includes a set of representations and warranties made by the company and another set made by each of the investors. The company’s representations and warranties may be modified and supplemented based on investor preference for breadth of diligence, discoveries during diligence, the stage and industry of the company, whether it is subject to regulatory oversight and other factors. This section of the SPA contemplates that any representation or warranty that is not accurate will be corrected by a supplemental document disclosing such inaccuracy called the Disclosure Schedule.

ii The NVCA Certificate of Incorporation

The NVCA Certificate of Incorporation (the Charter) is one of the two required governing documents under Delaware law, and it sets forth the rights, preferences and privileges of the company’s capital stock. The Charter is one of the more negotiated documents. Among other matters, the Charter sets forth rights of the holders of preferred stock to dividends, liquidation preferences, voting matters, conversion, anti-dilution protection and redemption. With rare exception, US start-ups do not pay dividends, and these provisions are generally not heavily negotiated. In general, there is no specific dividend set forth in the Charter, and this provision defaults to a requirement for equal sharing of any dividend declared on the common stock. The liquidation preference in the Charter provides that, in connection with a deemed liquidation (e.g., change of control and liquidation), the holders of preferred stock should receive a preferential payment amount before the holders of common stock equal to the greater of:

1. some multiple of a return on their invested capital; and
2. what they otherwise would have received if the preferred stock automatically converted into common stock.

In the more founder-friendly period of the past decade, liquidation preferences were almost always limited to a 1x multiple. However, in 2022 and the first half of 2023, in order to avoid down rounds and due to increased investor leverage, more deals have been including higher liquidation preferences, such as 1.5X, 2X and even 3X. The Charter will include voting provisions that specify which classes or series, or both, are authorised to appoint and remove directors as a matter of Delaware law. Individual persons and funds cannot be listed in the Charter. These rights only arise under the Charter as a result of a person owning capital stock of the issuing company. The Charter will also include protective provisions, which set forth various class or series, or both, votes that enable the holders of preferred stock to block certain actions by the company. The conversion section will initially enable the preferred stock to convert optionally on a one for one basis into common stock and include triggers (i.e., closing of a qualifying initial public offering and vote of holders with a threshold percentage of preferred stock), forcing automatic conversion of the preferred stock. In addition to mechanical conversion provisions, the conversion section includes price-based anti-dilution protection, which usually defaults to the more founder friendly broad-based weighted average anti-dilution, rather than full ratchet. Finally, the Charter may include redemption provisions requiring the company to repurchase the preferred stock upon the occurrence of time-based or other triggers. Redemption rights are considered very investor-friendly and are not common in US venture deals. However, in 2022 and the first half of 2023, in order to avoid down rounds and due to increased investor leverage, more deals have been including redemption rights.

iii The NVCA Voting Agreement

The NVCA Voting Agreement (the Voting Agreement) is one of the three stockholder agreements and is typically signed by the company, the holders of preferred stock, the founders and as many holders of common stock as possible, but generally no less than all holders of 1 per cent or more of the common stock. The two key provisions of the Voting Agreement are the director designation provisions and the drag along. The parties contractually agree as to how the directors will be designated, appointed, removed and replaced. Whereas the Charter can only specify that director designation rights belong to a class or series of stockholders, the Voting Agreement can specify an individual person or fund that can appoint such person and specify the individual who is to be appointed as a director. The other key term in the Voting Agreement is referred to as the drag along. Assuming certain conditions are met, the drag along enables the preferred holders and the company’s board of directors to force all other parties to the voting agreement to vote in favour of, refrain from exercising statutory dissenters’ rights and otherwise enable the sale of the company. The Voting Agreement also includes a proxy to enable a company designated officer to vote shares consistently with the Voting Agreement for any stockholder that fails to vote or votes in violation of the Voting Agreement. The proxy enables enforcement of the director voting provisions and the drag along.

iv Investor Rights Agreement

The NVCA Investor Rights Agreement (the IRA) is another one of the three stockholder agreements and is typically signed by the company and the holders of preferred stock. The IRA contains various rights, subject to certain exceptions and cutbacks, for the holders of preferred stock to have their stock registered in a public offering. Demand registration rights permit holders of a certain threshold of the preferred stock to force the company to file a registration statement. In theory, demand registration rights could be used to force a company to go public through an initial public offering; however, in practice, these rights are rarely used to do so and more commonly used to require the company to file resale registrations after the issuer has already gone public. Piggyback registrations rights are also included that allow the holders of preferred stock to include their shares in a registration statement otherwise filed by the company. The IRA also includes information and inspection rights that require the company to provide the holders of preferred stock, or some subset of those holders, with financial statements, budgets, business plans and other deliverables, as well as the right to inspect the books and records of the company during regular business hours. Another key term in the IRA is the pre-emptive rights or right of first offer, which requires the company to first offer any new securities, subject to certain exceptions, to the holders of preferred stock or some subset of those holders. If negotiated by an investor, other ongoing covenants, including the right to a board observer, will be contained in the IRA.

v Right of First Refusal and Co-Sale Agreement

The NVCA Right of First Refusal and Co-Sale Agreement (the ROFR Agreement) is the third stockholder agreement and is typically signed by the company, the holders of preferred stock and certain holders of common stock (the Key Holders), including the founders, key employees that hold common stock and often holders of 1 per cent or more of the common stock. The right of first refusal requires that any Key Holder that proposes to transfer their capital stock must first offer that stock to the company upon the same terms as the proposed transfer, and, if the company does not elect to purchase the capital stock, then the Key Holder must offer that stock to the holders of preferred stock upon the same terms as the proposed transfer. To the extent that neither the company nor the holders of preferred stock purchase all of the stock, such stock may then be transferred to the originally proposed transferee for a certain period of time and subject to the co-sale rights. The co-sale rights provide that the holders of preferred stock may elect to sell alongside the transferring Key Holder to the proposed transferee on a pro rata basis and upon the same terms as the Key Holder.

vi Brief regulatory overview

Similarly to VC funds, in the United States, start-ups typically raise capital in the United States in private offerings without general solicitation or general advertisement of the public by relying on Rule 506(b) of Reg D. Although technically Rule 506(b) allows up to 35 unaccredited investors to participate in the offering, in practice the disclosure burden of including any unaccredited investors in a private placement is impractical. Therefore, practitioners will generally advise that only accredited investors can participate in a Rule 506(b) offering. Rule 506(b) is heavily relied upon, in part, because there is no limit on the size of the offering, and thus as long as only accredited investors participate, it has minimal disclosure and filing requirements.⁴⁵ For compliance with Rule 506(b), the issuer only has to file a Form D⁴⁶ no later than 15 days after the first sale. Verification of accredited investor status is not required. The issuer only needs a reasonable belief that the investor is accredited, which can be satisfied through the inclusion of appropriate representations in the purchase agreement. Rule 502(d) also requires the issuer to exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of section 2(a)(11) of the Securities Act,⁴⁷ which can be demonstrated through the inclusion in the purchase agreement of disclosures that the securities are not registered and cannot be resold with registration or exemption therefrom, representations providing that the purchaser is acquiring the securities for their own account, and the inclusion of a legend on the stock certificate, warrant or other document evidencing the securities setting forth that the securities have not been registered.

Although crowdfunding for start-ups is permissible pursuant to Section 4(a)(6) and Regulation Crowdfunding promulgated under the Securities Act, it is not advisable for any company that hopes to raise capital from institutional investors. The goal of crowdfunding is to enable a company to raise small amounts of money from many investors, including unaccredited investors. Institutional investors like having a small and known group of investors around the table. Furthermore, crowdfunding is a relatively expensive method of raising funding with a relatively low cap. The total amount of securities that an issuer can sell in any 12-month period under Regulation Crowdfunding is only US$5 million.⁴⁸ However, the company incurs additional expenses of having to engage a broker-dealer or funding portal, since all transactions must occur through a registered broker-dealer or a funding portal.⁴⁹ Crowdfunding also requires the mandatory disclosures⁵⁰ and filing of an offering statement⁵¹ on a Form C⁵² with the SEC and ongoing reporting obligations that must be filed with the SEC and posted on the company’s website.⁵³

Exit

Venture capitalists rely on successful exits from sales and initial public offerings (IPOs) of their portfolio companies to return funds to their limited partner investors and to demonstrate returns that enable the venture capitalists to raise their next fund. Exits for US venture-backed start-ups are at a decade low.⁵⁴ In the first half of 2023, the value of exits by VC firms was only US$12 billion, which is less than 2 per cent of the 2021 exit value.⁵⁵ Despite overall US public markets performing relatively well⁵⁶ and Nasdaq increasing 30 per cent in the first half of 2023, the IPO window has remained closed since January 2022.⁵⁷

However, there are some signs that exits may be picking up in the near future. Liquid Death, a venture-backed beverage company, recently hired Goldman Sachs as the lead underwriter for a potential Spring 2024 IPO.⁵⁸ There are a few highly anticipated tech IPOs, such as Arm (a chip designer), Instacart (a grocery delivery service) and Klaviyo (a marketing tech company), which are anticipated to close in late 2023 or early 2024.⁵⁹ In July 2023, two biotech companies – Apogee Therapeutics⁶⁰ and Sagimet Biosciences⁶¹ – filed registration statements for their respective IPOs with price ranges. Furthermore, AI acquisitions have been heating up. AI is one of the few bright spots where both acquirers and venture capitalist are willing to invest. For example, in June 2023, Casetext, a provider of AI tools and services, was so sought after that it was sold to Thomson Reuters for US$650 million in cash before Menlo Ventures got the chance to close a financing on a US$400 million pre-money valuation that it offered to Casetext a month earlier.⁶²

Exiting through a business combination (e.g., a deSPAC) with a special purpose acquisition company (SPAC) was a popular exit in 2020 and 2021. However, deSPACs significantly decreased in 2022 and the first half of 2023 due, in part, to the poor performance in the public markets of companies that completed deSPACs, lawsuits against SPAC sponsors and directors related to deSPACs⁶³ and new rules proposed by the SEC to enhance disclosure and investor protection in deSPACs. The SEC’s proposed rules would require deSPACs to follow rules that are applicable IPOs, which would result in the loss of many of the advantages of conducting a deSPAC over a traditional IPO.

Outlook

There are signs that the outlook for start-ups may be improving or at least not getting worse. The US inflation rate was 3 per cent in June 2023, which was the lowest rate in two years and one-third of its peak rate in 2022.⁶⁴ Although it is anticipated that the Federal Reserve may still raise interest rates in July 2023, the lower inflation rates likely mean that any July 2023 raise would be the last raise. Tech layoffs peaked in January 2023, and the total monthly number of layoffs in the tech sector has decreased every month since January 2023.⁶⁵ Since being taken over by First Citizens, SVB has been increasing spend on marketing and advertising to get back in front of start-ups, founders and venture capitalists and to begin the repair of its brand.⁶⁶

From a regulatory perspective, the FTC has suffered major setbacks in its efforts to rein in acquisitions and increase the scope of antitrust enforcement. In February 2023, the FTC tried to block Meta from acquiring Within Unlimited, a virtual-reality start-up. A federal judge denied the FTC request to block the acquisition, and the FTC ultimately abandoned its efforts.⁶⁷ Furthermore, in July 2023, Microsoft was allowed to close its acquisition of Activision Blizzard after a federal judge denied the FTC’s request to block that acquisition. In denying the FTC’s request, the court found that the FTC had not demonstrated that it was likely to win on its antitrust claims. In both cases, the FTC relied on unusual theories of competitive harm to expand their enforcement scope. The rulings may indicate that the courts are generally unwilling to allow the FTC to expand its scope.⁶⁸ It is possible that a more restrained FTC will encourage larger acquirers to become more active again, spurring exits.

Investors anticipate a moderate increase in venture funding in the second half of 2023.⁶⁹ A significant amount of that funding will likely be received by AI start-ups. However, to meaningfully increase venture funding, venture capitalists need opportunities for successful exits. For there to be more successful exits and to enable the backlog of tech IPOs to hit the public markets, late-stage private tech start-ups must be willing to accept lower valuations that are attractive to investors, acquirers and public markets.⁷⁰ Those valuations have a long way to fall. In June 2023, the VC firm Coatue estimated that the overall market capitalisation of unicorn companies (i.e., private companies with valuations of at least US$1 billion) had been cut in half, compared to the company’s previous financing round.⁷¹ According to Forge Global, a marketplace for private company securities, private company valuations may have fallen even further. In May 2023, sales of securities in the Forge Global marketplace traded at a median discount of 61 per cent compared to the valuations in the last financing round of such companies. However, there are signs in the secondary markets that the valuation mismatch may be abating. According to Forge Global, the bid/ask spread decreased to its lowest percentage in a year in June 2023, reflecting more agreement between buyers and secondary sellers as to the valuation of private companies.⁷² Now it’s up to the issuers to accept the reduced valuations.