Dry powder versus wet powder: The numbers have spoken

Bridge rounds boomed at the end of last year

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Lux Capital partner Josh Wolfe predicted that “dry powder” would prove to be “wet powder ” as venture capital funds opt to support existing portfolio companies through rough times over making new investments. Data from Carta seems to confirm that his hunch was right: The frequency of bridge rounds boomed during the last quarter of 2022. — Anna

The calls for help might be coming from your own portfolio

One month ago, I warned that it would be a mistake to assume that the record levels of dry powder we kept hearing about would automatically go to new startups. While it is true that VCs in the U.S. alone are sitting on billions in overhang, they might have to dedicate a large share of this capital to supporting ailing startups that are already part of their portfolio.

This is why Lux Capital partner Josh Wolfe says that dry powder is actually already wet. “All the money raised at valuation peaks will get spent propping up ‘walking dead’ zombie companies that can’t raise outside money and instead have to turn to insider rounds,” he said.

It may be harsh to call these companies zombies; their struggles might only be temporary, and an injection of cash could bring them back to health. At least, that’s what many VCs seem to be hoping for — and they’re putting their money where their mouth is.

In this scenario, existing investors give more capital to startups that feel they’d be unable to raise their next round. Instead of trying to raise a Series B, for instance, they may do an extension round or bridge round on their Series A, backed by at least some of their existing investors.

This has been happening for months, and we should know: We’re alerted to new extension rounds practically every day. And perhaps just as often, we learn about startups that are hoping, and at times struggling, to secure that type of cash injection.

“In the past four to five months, everyone and their mothers has been looking for an extension round,” Navigate Ventures managing partner Ivan Nikkhoo told TechCrunch last July.

This trend has been even more pronounced in fintech, multiple investors from the sector confirmed last summer; so this isn’t news in itself. But we now have fresh data that helps us put numbers on what we have been hearing and seeing.

Recent data from the secondary marketplace shows that bridge rounds became more common during Q4 2022 at every stage, from Series A to Series D.

This finding is part of the company’s recent review of the State of Private Markets in Q4 and 2022, and while it is based on internal data, Carta’s reach is arguably wide enough that its data accurately reflects what’s going on in U.S. venture capital dealmaking as a whole.

The spike in bridge rounds was particularly high at the Series D stage, where they represented 31% of all rounds, according to the report. But the rise is happening across the board, with the share of bridge rounds at the Series A stage — 35% — higher than in any quarter since at least Q1 2020.

Bridges and consequences

Carta suspects that there is a correlation between bridge rounds and what it refers to as “one of the more counterintuitive trends of the year”: lower dilution rates. To Carta’s surprise, the median dilution rate remained low across all stages in 2022 and even diminished in some cases.

Why is that surprising? Because in a downturn, we would typically expect founders to accept less favorable terms and sell off a larger portion of their company in exchange for capital. But it’s not what has happened. And if that’s not the case, it may be in part because their new funding doesn’t come from new investors.

“[H]igh rates of bridge rounds may be another factor contributing to the reduction in dilution last quarter,” the report states. “If companies in need of a cash infusion that might typically raise primary rounds at higher dilution rates are raising bridge rounds instead, the median dilution of primary rounds that do occur might fall.”

But there are other possibilities as well. “This [low dilution rate] could be linked to the fact that investors were so picky in 2022: Only the very best companies were able to raise rounds at all, and perhaps those premium targets were still able to negotiate favorable terms.” Either this, or founders might be “more willing to accept smaller round sizes than they are down rounds,” which would cause the median dilution to sink.

One thing is for sure: The power balance is currently unfavorable to founders. Per Carta: “The broader market got much less founder-friendly in 2022, a fact highlighted by plunging valuations.”

Plunging valuations are a revealing data point about the state of the market; we are no longer in 2021. Yet, a case could be made that an overinflated number can be damaging in the long run, meaning that not getting a unicorn valuation is not necessarily bad for founders.

However, there are other data points that can only be seen in one light, and that’s investment terms. In most cases, they are either founder-friendly or investor-friendly. In recent months, it is much more often the latter.

New norms for terms

“Are founders getting term sheets with onerous, investor-friendly terms lately? True. [Carta] data shows multipliers over 1x are rising,” tweeted Peter Walker, Carta’s head of insights and the report’s co-author. In short, multipliers mean that investors are protected against losing what they invested when they get an exit. Founders had gained leverage against this clause but seem to be losing it again as a result of the downturn.

It’s also worth noting that these terms aren’t only the result of a power struggle between founders and investors: There’s also a battle at play between existing investors and new ones, and we have data on this, too, that shows how things have changed over the last few months.

Recapping 2022 data in its latest tech valuations report, research firm CB Insights noted that “last year, late-stage investors (Series D+) moved to retain power over liquidation preferences in an environment where far less capital chased fewer deals.”

CB Insights is looking at a clause known as pari passu, which it defines as “an arrangement whereby, in the event of an exit, investors across all deal stages share proceeds pro rata to the amount of capital committed.” To keep things simple, let’s stick to its explanation of how that clause has been declining:

“In the U.S., 44% of late-stage deals in 2022 (and 50% in Q4 2022) were negotiated with seniority or tiered payout structures — rising from the norm set over the previous two years. Global late-stage deal volume in 2022 fell 36% year-over-year, retreating to levels seen in 2019 and 2020,” CB Insights summed up.

Comparing 2019 and 2020 makes the change relative, as terms had already become a lot friendlier to founders than they were a decade ago. This brings us back to a recurring question: Maybe 2021 was the anomaly all along? This year should help us find out.