As reported by CB Insights, global funding for startups dropped by almost 25% between Q1 and Q2. Similarly, US startup funding dropped to $52.9 billion in Q2, making it the lowest quarter since 2020. But what does all this mean for early-stage startups during H2 2022?

Fewer deals, fewer exits

On top of the reduced amount of funding, deals and exits are lower. The same CB Insight reports suggest deals are down 15%, with investor exits down 16%.

So, how did we get here, and what does it mean for early-stage startups going forward?

Factors affecting funding

The pullback in startup funding is occurring during an overall period of market instability. Here are some of the economic and social situations that are affecting investing in 2022.

Inflation

Inflation has been spiraling out of control. It's currently around 9.1% — the highest rate seen in 40 years. There are several causes, including financial stimulus programs and supply chain issues due to the COVID-19 pandemic.

To tackle inflation, the Fed has proposed and implemented interest rate hikes. As a result, money is more expensive to borrow, which reduces liquidity. In theory, this means there is less money for investments.

Inflation is a big problem for companies in the growth sector. Investors get into these businesses based on the promise of significant gains down the line. However, high inflation makes those eventual gains look far less appealing.

Equity market slowdown

The S&P 500 is down more than 20% this year. Tech stocks like Meta, Apple, and Amazon are some of the biggest culprits. This situation has led some investors to pull away from tech stocks, and it’s also influencing how VC funds see these opportunities.

Potential recession

Unsurprisingly, there is not a lot of consensus among economists about whether we are heading towards a recession. A lot depends on whether the Fed can dampen inflation with interest rate hikes without stifling economic growth.

Crypto collapse

The cryptocurrency market, which had reached all-time highs in 2021, collapsed spectacularly this year. Bitcoin is down 60%, Ethereum almost 70%, and many exchanges and companies have collapsed, including Luna, Three Arrows Capital, Celsius, and Voyager.

Geopolitical instability

Russia's invasion of Ukraine has led to an uncomfortable level of geopolitical instability. Additionally, it has worsened inflation due to rising oil and food prices.

Tech layoffs

While US job data has been pretty good this year, there have been many hiring freezes and layoffs in the tech sector.

What are big VC investors saying?

Some of the biggest names in VC funding have been sounding a note of caution in recent months.

Sequoia Capital recently warned founders that they shouldn't expect a quick market recovery and that it's time to cut costs and preserve the runway. It's not entirely unexpected news; Sequoia has gained a reputation for being reasonably cautious. However, it's interesting to note that they're still making deals at roughly the same rate as they did in 2021.

Other big names that seem to be pulling back are Softbank, A16z, YCominator, and Tiger Global.

Are valuations down?

While investment is down in the broader startup space, it's worth looking at the numbers more closely. According to Crunchbase data, Series A funding was down 20% from H2 2021 to H2 2022. However, figures are still higher than H1 2021 and above the 2020 average.

So what does this mean for early-stage startup funding?

Firstly, it's worth noting that the funding pullback is disproportionately affecting late-stage funding. IPOs are frozen, and the days of big deals with revenue multiplications of 100 or more seem to be over.

In light of the Fed's interest rate hikes, many investors are fleeing to safer markets. We've seen investors turn away from companies heavily reliant on securing more capital to stay operational.

For larger startups, this environment is starting to bite. Fintech darlings Klarna were raising funds at a valuation of $46 billion in 2021. Now, they've priced themselves at $6 billion.

For early-stage businesses, funding is becoming more challenging. The money and interest are still there, but VC funds are looking for more value.

Early-stage investors are reporting that they are facing far more scrutiny from investors. For example, investors are asking for burn multiples and the magic number at a higher frequency.

In effect, investors want some sort of assurance that whatever capital they put into a company will be able to last for a while. This caution reflects the new reality that the era of cheap cash is over and that sustainable growth is more important than ever.

Additionally, many founders are reporting that deals are taking longer than usual. That's probably a good thing for everyone. More due diligence — for both parties — should lead to better long-term relationships and decisions.

What should early-stage startups do?

The era of cheap and easily accessible capital is coming to an end. A faltering equities market, high inflation, and raised interest rates will all lead to a tighter market.

With many big players, like Softbank, Tiger Global, and A16z, all pulling back from late-stage investments, an opportunity has emerged for seed and early-stage startups.

If VC funds adopt a more defensive position, they'll gravitate towards high potential, younger startups. In this climate, deal sizes may become smaller, and investing more conservative. So, early-stage startups need to adjust to appear more attractive long-term.

This situation underlines the importance of a solid, easy-to-digest business model. Startups that are just burning through cash without profitability in sight will struggle in this setting.

VC investors' risk appetite is lower. Expect increased interest in sustainable growth and realistic valuations. Additionally, more due diligence will be required before cheques are signed.

Conclusion

Startup funding is down across the board. However, late-stage companies seem to be most affected.

Early-stage and seed investment has taken a slight dip from the heights of 2021, but there are still many interested investors. Sure, the economic climate has caused investors to be more cautious, but good businesses will still cut through the noise.

Founders need to be prepared to adjust to this new environment. As VC investors look to mitigate risk in an uncertain economy, expect more questions and due diligence. Solid businesses with strong roadmaps and financials will still appear attractive.