Canadian VCs have $10B (CA$13.2B) in dry powder available for deployment into startups, per a BDC Capital report. Despite the availability of substantial dry powder, capital deployment in Canadian startups in 2023 is expected to remain below 2022 levels as fund managers will be selective about their investments. Funding will remain limited for startups until the valuation deadlock between founders and VCs clears up and both can reduce the bid-ask spread. BDC Capital estimates that nearly 50% of Canadian startups will need to raise funding over the next 12 months. Startups that are unable to raise additional equity funding will turn to venture debt financing or look at M&A options as their cash reserves dwindle. However, as more and more VC-backed startups run the risk of running out of cash, founders will need to accept valuation cuts to raise follow-on funding from investors. The monetary tightening in 2022 and the increased interest rates mean that the valuations from 2021 are no longer sustainable. This prompted several VCs to already cut valuations of portfolio startups. Meanwhile, startup founders were refusing to take valuation cuts and opting for other non-dilutive forms of financing, such as venture debt, to avoid repricing. Additionally, VCs were focused on making follow-on financing in current portfolio startups, "insulating their best investments from any further market shifts," per BDC Capital, instead of backing new startups. All these factors combined resulted in a 54% QoQ drop in VC funding in Q1 2023, continuing the 34% YoY drop in 2022. The decline suggests that deal values and sizes were returning to pre-pandemic levels. Per Bloomberg, the average size of transactions already dropped by 24% in 2022, dropping from $13.8M (CA$18.8M) in 2021 to $10.4M (CA$14.2M). Deal sizes of Canadian startups are now inching toward the average values of (CA$11.7M) from 2019.
Investors are waiting for valuations to drop even further, knowing very well that previous valuations of many of the startups won't stand in the current market conditions. By curbing their investments, VCs are holding out for better deals at a later stage, hoping to scoop up startup stakes at discounted valuations. This is evident from the number of flat rounds, which increased from 14% between April 2021 and March 2022 to 48% between April 2022 and March 2023 across BDC's direct investments. The number of down rounds increased from 2% to 6% in the same period, while up rounds declined from 84% to 46%. The 2021 year can be considered an outlier in terms of funding and valuations. Canadian startup founders and VCs are now beginning to move away from the inflated metrics of 2021 and settling for more conservative values as the market reverts to pre-pandemic levels. |
