How inflation will impact VC spending

As Australia enters an economic downturn, venture capital investors will be making smarter investment decisions.

Leo Wang, senior analyst at PAC Capital said the next year will be a tough time for many startup founders.

He said founders are used to an environment where all they need to get funding for the next round is to deliver revenue growth.

“It is just taking money from the last round translating into marketing dollars, in order to get further money for the next wave of customer growth. That used to be the dynamic within the industry for a good number of years,” he said.

“But now you need to combine not only top-line growth but deliver profitability at the same time.”

Wang said this added expectation is a test for many founders.

“If they aren’t able to actually recognise that this shift has occurred, structure their business in a much more efficient way and operate their business in a much more efficient way, then they're likely to not survive this coming belt-tightening period,” he said.

Many of the venture capital companies are pulling back on funding and focusing on companies that can survive the next couple of years, rather than sort of spreading their bets across all their portfolio companies, Wang explained.

“What that means is that we're going to see a wave of bankruptcies and closures within the sort of venture capital space. Within that a lot of relatively more fraudulent or relatively more bullish founders that aren't able to execute, are going to get washed out,” he said.

Wang said the general increase in interest rates is probably the more important variable rather than inflation itself as a reference to venture capital markets.

“With higher rates of interest, the value of cash flow that is closer in time is going to be worth far more than cash flow that is later down in the future. Whereas if you had interest rates that weren't zero or near zero, investors didn't care between money today or next year versus money in 10 years' time,” he said.

“With the environment of high-interest rates, going from near zero to four to five percent, it means there is a general pressure for all venture capital companies to deliver profitability, and to deliver cash flows today.”

Wang said this is because the relative attractiveness of the valuations that can be applied to their companies is going to be much lower for the same dollar amount of cash flows delivered in the future.

“This has created is an environment of cost-cutting, and belt-tightening across the entire industry, which effectively becomes a negative feedback loop,” he said.  

“As you know, customers and companies that are aware we're spending money within the technology ecosystem, everyone cuts back at the same time, which creates a negative environment for these venture capital companies.”