How VCs Will Navigate A Chaotic Investing Environment In 2023

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The past year has been chaotic for venture capital investors – crises like the war in Europe and stubbornly high inflation have created economic volatility and an unpredictable investing environment. While 2021 saw surging VC deals, exits, and valuations, those numbers contracted significantly in 2022. The companies in the best position to navigate 2023 will be the ones that focus on innovation in rapidly emerging sectors like cybersecurity and climate while maintaining capital-efficient businesses.

VC investors will be taking a close look at companies that have demonstrated resilience in 2022, and which have strong value propositions enabling them to capture market share in an unpredictable economic environment. The biggest theme for VCs over the next year will be adaptability. As the possibility of a recession, high interest rates, and inflation continues to remain high, companies won’t just need to be capable of responding to these crises – they’ll also need to be incredibly nimble to respond to the customer, market, and economic opportunities in the chaos, volatility, and unpredictability that surrounds them.

While VC investors will continue to be circumspect in 2023, they’ll also be on the lookout for companies that are developing novel solutions to the world’s most pressing problems. VCs have almost $300 billion in dry powder, and they’re eager to move it off the sidelines.

The elements of a VC recovery

After one of the most robust years for VC firms on record, 2022 has been filled with revaluation, resetting, RIFing, and restructuring. VC funding peaked at $70 billion in November 2021, but collapsed to $39 billion in May – its lowest monthly level since November 2020. Global VC funding decreased by 34% from the second to the third quarter – the largest quarterly drop in a decade and a 58% decline from the fourth quarter of 2021.

However, the amount of dry powder VCs have at their disposal continues to rise. As inflation shows signs of moderating and the labor market begins to cool (a key component of the Fed’s decision-making process on interest rates), certain elements of the economy are in the process of stabilizing. There are still many unknowns, though, which means VCs will need to see healthy balance sheets and the satisfaction of rigorous performance metrics. Multiples in the public market have compressed significantly on an annual basis, which means companies will need to grow 2.5x more quickly just to receive the same valuation they did in 2021.

VC investment levels aren’t going to recover overnight. Beyond the economic uncertainty funds are confronting right now, the deployment of capital is more data-driven than ever. VCs are also prioritizing specialization in terms of stage, sector, and other focus areas (from network effects to tech stacks to revenue growth). But with the amount of dry powder waiting in reserve, expect investment levels to begin recovering in 2023.

Identifying the most dynamic investment areas

This is a turbulent period for VCs and the companies they support, especially in certain sectors. For example, crypto and blockchain have taken a massive hit in 2022, which means future projects will have to meet a higher standard than before relative to traditional alternatives. But while some fields are going through a contraction (which won’t last forever in crypto), others are growing inexorably.

Take cybersecurity, for instance. According to the 2022 IBM Cost of a Data Breach Report, the average breach inflicts $4.35 million in financial damage, while 83% of the organizations studied have suffered more than one breach. The FBI reports that the total losses caused by cyberattacks rose consistently between 2017 and 2021, while supply chains and critical infrastructure have increasingly been targeted by cybercriminals. As the digital transformation continues to gain momentum (from the exploding Internet of Things market to the increasing reliance on cloud-based communication and collaboration tools), cybersecurity will only become more important.

Then there’s climate change, which Deloitte believes could cost the U.S. economy $14.5 trillion over the next 50 years if insufficient action is taken to arrest rising temperatures. As the Federal Reserve and major financial institutions game out climate risk scenarios, it has never been clearer that private sector innovation (which is often backed by the VC industry) is integral to mitigating the worst consequences of climate change.

Lastly, while cyber and climate look particularly promising, we continue to see many promising opportunities in cloud, SaaS, consumer, and other markets that enjoy high levels of technology in transition. We are particularly seeing artificial intelligence technologies (NLP, speech recognition, machine learning, deep learning, RPA, cyber defense, etc.) pervade both our existing portfolio as well as prospective pipeline.

What to expect from VCs in 2023

With so much dry powder available, it’s easy to imagine some level of competition for VC funding in 2023. But this is only half the story – VCs will also compete against one another to invest in promising startups, and this will be healthier for the ecosystem in the long run. Early-stage companies shouldn’t have to dedicate so much time and resources to chasing funding, especially when the ideas they generate will be pivotal for addressing some of the world’s biggest problems.

Several strategies should guide VC investors in 2023. First, it’s crucial to identify companies that have shown financial resilience over the past couple of years, which means taking a close look at rule of 40, LTV/CAC, and other capital efficiency metrics as well as balance sheets and peer benchmark performance. Second, firms should develop a more focused investment thesis which takes size, stage, and sector into account. Third, VCs need to recognize which companies have strong value propositions in dynamic, emerging sectors like cybersecurity, climate, and AI/ML. Fourth, customer acquisition and go-to-market management strategies should be more data-driven than ever before.

The point of investment is to improve a company’s overall long-term performance. The best VC funds don’t just cut checks and hope for the best – they’re strategic partners that help their portfolio companies scale sustainably, navigate difficult economic circumstances, and ultimately grow revenue. Whether it’s the identification of new market opportunities or revenue streams for their portfolio companies, the ability of VCs to support their portfolio companies will be critical in 2023 and beyond.

Finally, we’ll continue to see greater differentiation and specialization among VCs. Companies have different constraints, advantages, and goals, and the VCs capable of providing specialized support will forge healthy long-term relationships. These relationships will give VCs and their portfolio companies a major competitive advantage in the coming years.