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Crisis after another crisis - is the expected investment winter justified?

It was back in 2020 when the whole world stopped for a minute because the Covid pandemic hit the global economy really hard. That was a reality check for many investors and startup founders as there was not much that they could do against a global virus. Some of the largest Venture Capital funds that have access to the global data due to investment linkages throughout the whole world issued statements about how the startups should get ready to overcome the quickly emerging crisis.

The most popular memorandum was issued by Sequoia Capital, named “Coronavirus: The Black Swan of 2020”, providing an insight on what to expect and how the coming crisis will impact the daily business operations. There were precise instructions to make sure that every assumption is correct - cash flow, operations and strategy. Now the time has come for the next warnings by the larger Venture Capital funds, the same Sequoia Capital held another presentation to caution founders, right after the Y Combinator did so and so did many others. The warnings mostly related to not bringing up expectations to recover as it was after the pandemic and, of course, to plan for the worst.

Many startups could not overcome the global Covid disruption even with hundreds of millions in received funding. Running out of cash due to limited possibilities to raise more at the time and distractions in operations were only some of the reasons. Those who overcame were mainly those who managed to optimize expenses and had planned a big enough runaway or somewhat related to the digital transition which directly related to convenience tools and solutions for the new world's order. Tech sector saw a raise in their values, innovative tech startups experienced enormous growth and a significant raise in funding.

For a moment the world felt the upturn after the two years spent in endless restrictions and limitations, while also being in complete uncertainty about the future. Some had already made the decision to continue transitioning to the digital environment - startups had started hiring more and more people remotely and remote - digital culture has become the new normal. Latvian Lokalise - Latvian soonicorn is just one of the such examples of the company's complete transition online, that was done right after the completion of the Series A funding round, which later led to another funding round of $50 million at the end of 2021.

Now looking back, 2020 and 2021 were the one of the greatest years in the global business in terms of made investments, raised capital, right after the year that many believed to be their last. These years brought large valuations, constant funding rounds, and for a moment it seemed that the world is on its new tech breakout that is going to last for some great time.

Speedy economic recovery was one of the preconditions for returning to normal life, where people have the purchasing power to participate in the economy that had just been reanimated from the pandemic. One of the main solutions from the policymakers was to start printing money in order to be able to heal the economy, such monetary policy decisions could have played out well if it was not for the war that emerged in Europe, with it directly affecting one of the main economic centers in the world and bringing the chain reaction towards the others. The rise in gas and oil prices as a result was unavoidable, and so did grain, steel and other basic commodity prices.

Nasdaq in November 2021 revealed that the Covid costs by March of the same year had already totaled $5.2 trillion with total printing reaching $13 trillion in the US. While Reuters already in March 2020 wrote that the European Central Bank had approved a 750 billion euro bond purchase scheme for shoring up governments and also saying that it would not apply the self-imposed limits. The European package was later extended to 1.85 trillion euros by more than doubling the initial amount. More money means more purchasing power, therefore higher demand for products, which combined with Ukraine-Russia war caused supply chain delays, higher everyday living prices due to increased utility bills and, therefore, has caused the inflation to reach decades-highs. The statistics only reaffirm the disastrous situation - in 37 of 44 advanced economies the inflation rates have doubled in the last two years.

Venture Capital wise this effectively stipulates that the capital is going to get more expensive, with less “free capital” available, more careful investment decisions, therefore more grounded valuations. For startups this means that more efficient operations are to be expected and that they have to come up with clear strategies on rather steady and cost-effective scaling than aggressive cash-burning ambitions. Drawing parallels with the Covid Black Swan memorandum, the companies must optimize in order to survive and also be able to scale.

Potentially the deep tech startups could get some more attention in the following years. Even though the deep tech startups are slower in terms of growth speeds, they might provide certainty for investors with convincing research and reasoning for success rather than startups that are asking for a lot of money for exponential scaling, which might as well fail due to competition, better solutions or failed marketing. Sifted in June, this year, reported on Latvian deeptech sector naming it as one of the main growth sectors in the Latvian startup ecosystem. The article recalled on statistics that state that more than 1 in 10 Latvian startups are from the sector, combined with the growing higher education levels, could mean that there is yet some potential to be fulfilled. This is good news for startups like Latvian Aerones and CENOS that have already had their fundraising rounds, meaning that the next funding rounds will happen as they will pose certainty among investors with already proven and powerful end-products.

On the other hand, companies like Bolt, will have to find the way to become profitable, as the investors will start to choose the more certain investments instead of a raw Venture Capital push for scaling up. The Estonian giant just recently announced its 2021 financial data, revealing an unpleasant picture - the company has concluded the fiscal with almost 550 million euro losses, the big question here is, whether they will become profitable or whether the investors will give more money when they run out of it? That is one to be answered in the nearest future, when we will see how the new investment strategies are implied.

The cost optimization also relates to the big tech companies as no one is really protected from the raise in costs all around. Google is currently laying off recruiters and is closing engineering offices in both the EU and the US. CEO of Tesla Elon Musk announced that the company's payroll should be reduced by about 10% from the development and engineering departments. Meaning only that the big tech companies are also tightening their belts to cut costs where they can be cut without affecting the company's daily operations. This will slow down the development of new products, but it still will continue, just with a little bit of caution.

For now, it is clear that the investment and development activity will decrease in the near future all around the world as the cost of money is becoming higher and, therefore, it will be harder to raise Venture Capital funds as such. As one of the main reasons to mention is the investor willingness to join a fund, which takes a lot of risk appetite. In uncertain times like these they will rather choose to invest in more short-term and guaranteed return of investment projects than in venture funds, where the return is not guaranteed or takes a longer period of time. The fall in Venture Capital investment volumes can already be seen in the most recent statistics with the current QoQ change standing at -26% and YoY change at -27%. Number wise Q2 of 2022 has fallen to the lowest point since the investment boom started in Q1 2021. For comparison, at the peak, in Q4 2021, the early and late stage investments stood at $60 billion and $95.8 billion respectively, while in Q2 of 2022 the numbers were significantly lower, standing at $44.2 billion and $59.5 billion.

Does that mean the investments will stop at all? Definitely not, as the brightest examples to mention are Sequoia Capital which just began to raise two US-focused investment funds in the amount totaling up to 2.25 billion dollars. For Europe-based investment funds, the Austrian 3VC just launched a 150 million euro fund with the focus on promoting sustainability and diversity, while the Amsterdam-based Acrobator announced a EUR 30 million fund with preferences of EUR 150 thousand to EUR 1.25 million investments in data-focused machine learning technologies.

These aforementioned European funds are only a couple of the funds that are available for Baltic startups. The Tallinn-based Superangel just announced a EUR 50 million fund for early-stage startups, while the Helsinki and Stockholm-based Butterfly Ventures announced the close at EUR 47 million for seed and Series A and B round investments, also available in the Baltic region. Both of these funds will be tended to invest in science based businesses, which directly relates to the investment strategies that are taking shape right now, meaning more stability, growth and certainty.

There are a couple more investment funds and syndicates with Latvian roots that only just recently have started to make investments, where the Change Ventures Fund II of EUR 49 million, which at the time of closure, in the beginning of 2022, became the biggest seed fund in the Baltics and the recently announced syndicate which made its first investment only at the beginning of July 2022. There are also other private money investors, such as Venture Faculty, for which nothing has stopped and the company is still willing to invest and help raise money for startups.

Considering that the funds are still raising money and there is some more accumulated money in private investors pockets for use, the complete picture does not seem to be as bad as some might think. The funding for Baltic startups is and will continue to be available for at least the next couple of years as there are still multiple fresh funds with a considerable amount of cash and so the private investors are. By that time, the global and regional economic situation should be seeing some improvements.

In the previous article we looked at the completely established self-sustainable funding cycle in the region, marking the funding and new idea accessibility in the fast-developing startup landscape of the Baltics, meaning that we have a bit of all - unraveled potential and money to invest in it. This combined with more cautious investment strategies mean that the high potential startups will still keep getting the money for growth. This also applies to the deep tech sector, where Latvia has some of the hidden potential that is yet to be explored, which in the light of the current situation could be getting some more attention than it used to get. While it might be possible that it will be harder to attract investment from outside, the great startups can be funded internally, so when this investment winter is over, they are well established and attractive for outside investment.