We send quarterly investor letters to our LPs about what we're seeing in the Latin America startup market. We share edited versions with our portfolio. We’ve decided to share a further edited version publicly.
Hope you had a great first quarter!
We’re happy to share that in Q1 we did a first close on our new fund, Magma 4, and started to deploy capital into new opportunities at attractive valuations, which are up to 80% lower than during the peak of the hot market in 2020/2021.
We’ve been working closely with portfolio companies from Magma 2 and Magma 3 to help them navigate the changing market, while keeping our finger on the pulse of how AI is starting to impact startups. We’ll cover:
- Changes in the Latin American startup ecosystem over the past 18 months
- Today’s market
- Lower valuations, tourist capital is gone, focus on margins at the expense of growth, down rounds and more structured rounds
- Helping startups navigate the market
- Our advice to founders, how they’re reacting and our job going forward
In letters over the past 18 months we’ve covered:
- Zero interest rate policy (ZIRP) distorted the VC market into a bubble (Q4 2021 letter)
- How going from 0% to 5% interest rates reset valuations for public market technology companies (Q3 2022)
- VC funds that YOLO’ed money into growth at all costs startups at high valuations might have trouble raising new funds (Q4 2022)
- Dry powder (undeployed VC capital) founders were banking on was actually wet powder that was mostly committed to save those VC’s portfolio companies, not fund new opportunities (Q4 2022)
- There could be a potential mass extinction event for startups in Q3/Q4 2023 (Q4 2022) that didn’t adjust to market conditions
The opportunities that these macro headwinds would bring:
- Lower valuations and entry points for Magma to invest in great companies
- Less competition from tourist capital that left Latin America
- Better, stronger founders, not some of the wantrepreneurs (wannabe founders) that started companies in 2020/2021
- Less competition for talent and lower employee costs for the capital efficient startups that survive
Magma is well positioned because:
- Magma mostly avoided the most extreme bubble-boosted valuations of 2020/2021
- Magma’s mix of elite status founders with underestimated founders brought significant diversification to our portfolio, finding winners most others didn’t
- We’ve been ahead of the curve, telling founders to raise money and cut burn as early as Q3 2020 and communicating with founders to help them understand the market reality and change in VC sentiment
- We have dry powder to deploy into our best companies at attractive valuations
This isn’t to say that we won’t have write offs and down rounds across portfolio companies. We will. That’s the nature of the VC game. But we believe we’re positioned to do well in the face of the sea change in the VC market.
Today’s market: Lower velocity, lower valuations, down rounds, the potential leading edge of startup failures
The VC market moves much more slowly than public markets. It took 2-3 quarters for valuations to reset and this reset is still filtering through the market. In Q3 and Q4 2022 investor letters we talked about how there could be a potential mass extinction event for startups near the end of 2023 and into early 2024 as startups that raised at inflated valuations in 2021 needed to start raising new rounds in late 2023 and early 2024.
We’re starting to see the leading edge of these failures and down rounds. We’re not 100% convinced that huge numbers of startups will fail across the ecosystem, but it's looking more likely there will be heavy handed revaluations of many of Latin America’s more well known startups, especially those that could not lower burn enough to control their own destinies.
These startups are just starting to come to market to raise. We’ve seen deals at up to 90% discounts from previous rounds, pay to play and high liquidation preference structures in companies with significant revenue, but poor unit economics and high, inefficient burn. Others are unable to raise at all.
Only the very best companies are able to raise significant capital at good valuations, and even those that are doing well face multiple compression. The winners we are seeing right now are companies that built a warchest in 2020/2021 and cut burn aggressively so that they can control their own destinies and not be at the mercy of some of the VCs that are in the market with very aggressive deal terms. Some terms include:
Pay to play - A new investor requires all previous investors to invest their pro rata of the new round or take between 80-95% dilution.
Liquidation preference - The standard structure is a 1x liquidation preference, which means that investors get 100% of their original investment back first before common shares (founders and employees). We’re now seeing 2-3x liquidation preferences, which means that the newest investor gets a 2-3x guaranteed return off the top before everyone else, including earlier investors.
Warrants and Anti Dilution - Some term sheets include additional warrants and full ratchet anti-dilution clauses, which means that the new investor gets additional equity if there’s a future downround or if the company does not hit its milestones. Or the fund has the option to invest more money at the same valuation for 1-4 years.
Most founders have never seen these types of terms before, and don’t realize that if they are in a position where they do not control their own destiny, they might have to take a new investment that not only mostly wipes out previous investors, but also puts a huge amount of money into the waterfall before the founders ever see a dime (or a peso). So far, our largest companies have avoided these types of structured rounds, preferring clean deals generally at lower valuations, which in our opinion is the right decision for the long term.
Dry powder is really wet powder and mega funds are struggle to raise new funds
The potential dry powder that some founders expected to be available, which we predicted would more likely be uninvestable wet powder, is not materializing. VC funds are using their uncalled capital to fortify their best companies and save others that are on the verge of failure.
VC deal pace from especially the biggest funds, is way down. According to The Information, here’s how 3 of the biggest funds during the boom are behaving now:
- 21 deals in 2023
- 309 in 2022
- 356 in 2021
- 3 deals in 2023
- 18 in 2022
- 31 in 2021
- 31 deals in 2023
- 191 in 2022
- 239 in 2021
At the same time, new VC fundraising is slow, especially at the megafund level.
Top tier later stage fund with $90B AUM started raising a new $20B fund in June 2022. A year later, they closed $2B.
As of Q1 2023, the global fund is no longer investing and actively looking to sell assets to raise cash. In Latin America, nearly the entire team left, and 2 of the original partners are starting their own fund and being very valuation sensitive to deploy any new capital.
Started raising a $12B fund 18 months ago. Closed $2.7B fund and actively looking to sell individual portfolio company assets to raise liquidity.
Silicon Valley fund started by Peter Thiel closed a new $1.8B fund in 2022 and decided to take the final $850M from the fund and create a new fund with the remaining money. This change means less management fees now, but also likely gives Founders Fund’s team a better chance of making more money on carry.
Magma advice: cut spend, be more capital efficient, take standard terms at lower valuations instead of structured rounds to defend valuations
We have consistently advised founders to be more conservative because of market forces outside of their control like inflation, interest rates and lower VC capital availability. We even pushed companies that were doing well and had 3+ years of cash in the bank to cut at least 10-15%. Our mantra has been:
“If the best companies in the world like Facebook, Google and Microsoft are all cutting, you should be cutting too. If you cut too far, you can always hire people back.”
No founders that cut regret cutting too much. Many founders who did not cut or didn’t cut enough have regrets. Some are out of business.
We want portfolio companies to control your own destinies. That doesn’t mean companies have to be profitable, but it means that founders have to have a controlled, reasonable burn for their size/stage, 18+ months of runway in the bank, and a plan to survive if they can’t raise money at reasonable terms by cutting burn and increasing revenue to extend runway.
Our write offs and write downs in Funds 2 and 3 are both still well below our models, with under 12% of capital in non-performing companies. Fund 4 has 0% of its capital in non-performing companies so far.
Most of our relevant companies can control or mostly control their own destinies. Some still can’t, but are working toward it and we are proactively marking down these companies on our fund valuation to be on the conservative side. This process is playing out across all venture backed startups around the world and in Latin America.
It's likely we’re in a larger shift where interest rates are generally at this level or higher and there’s lower venture capital availability as the 2020-2021 vintages work their way through the system. This period might last longer than founders think.
It makes sense for founders to be more conservative than they think they need to be, take less risk and survive while the market is renormalizing. As Lux Capital’s Josh Wolfe says, “survival is the precondition of growth.”
How are founders dealing with the market shift and our advice to be more conservative?
It’s hard to tell a founder who is doing really well, has low burn, good growth and great unit economics that they won’t be able to raise at the valuation they’d hoped. But we have to do it monthly right now.
Many founders are still anchored to the last time they raised money 18-24 months ago and are not understanding the reality of the market. “We just need to ride out the storm,” they say. But in reality, the 2020-2021 period was the anomaly. 2023 is more likely to be the reality. While we do expect the funding ecosystem to get better in the future, it likely won’t jump back to 2020/2021 levels until the next bubble.
Most founders know they need to be aiming for efficiency, low burn multiples, faster payback periods and finding ways to generate free cash flow that can get invested back into the business’s growth. But muscle memory is hard to retrain. It’s one of our hardest jobs helping founders through this transition.
Some companies have successfully made the mindset shift, getting to a reasonable burn, or in some cases, even becoming cash flow or EBITDA positive. Others have not, even though we’ve time and again pushed them to make the tough decisions they need to do to be successful, but in the end, even with a board seat, in venture backed startups, the founders generally can do what they want and ignore our advice. We will continue to work hard with our portfolio to help them during this market shift.
The Latin America ecosystem going forward + Magma opportunities
Some in the ecosystem are still in denial about the systemic changes happening to the funding markets, but in Q1 2023, we started to see more movement from both early stage and Series A companies to adapt to market conditions.
In Q1 2023, we saw an acceleration of deeply discounted Seed and Series A opportunities compared to 2021/2022. These discounted valuations generally were paired with larger round sizes, which means big dilution for founders and early investors and more ownership for VCs with capital to invest.
At the same time, we saw the first signs of capitulation in the pre-seed market, where asking prices stayed high for longer. Some founders finally started to ask for ~$3M-$5M valuations, rather than $10M-$15M Powerpoint rounds we still saw at the end of 2022.
Your Fund Size is Your Strategy
As Evan Armstrong and Bryce Roberts write, there’s a big correlation between your fund size and the outcomes you need to return at least 3x net to LPs. and With a maximum target of $50M, we are intentionally keeping Magma IV smaller than many Latin American funds. We believe many founders will need less money going forward, and that outcomes in Latin America might not reach the high end $10B-$40B valuations from 2020/2021 until the next bubble. $35M-$50M is the ideal size for an early stage Latin American fund with our thesis.
Here’s some basic math:
- A $1B fund needs to own 15% of 20 unicorns at exit to return 3x the fund, or 15% of two $10B companies
- A $100M fund needs to own 15% of 2 unicorns at exit to return 3x the fund
- A $50M fund needs to own 15% of 1 unicorn at exit to return 3x, or it can own 25% of two $300M companies
We are always looking for companies that can become unicorns, but our strategy does not require us to find one to drive top tier returns.
We think this strategy is optimal for an early stage Latin American VC because LatAm’s biggest exits in the modern era are:
- Nubank at $40B valuation
- Dlocal, Stone, Pagseguro and Auth0 at $5.5B-$6.5B.
- Cornershop between $1B-$3B
This math means that, for most VC funds over $150M, the VC fund's product is not for founders who won’t build a unicorn. Even if the VC invests, they are likely to push founders to take extreme risks that could turn a company that could be a $250M exit into a $0 write off by going hyper growth with poor unit economics instead of building something that changes Latin America, the founder’s life and drives returns for VC funds like Magma.
To be clear, we want the companies that should turn into $1B+ unicorns to do it and we hope to find the next Nubank someday. But founders can solve an industry problem and make a ton of money for themselves, their employees and their investors even if they don’t turn into a $1B+ company.
Conclusions: Turmoil in the markets, some founders are not reacting fast enough; lower valuations are a big opportunity to buy more ownership in great companies
We strongly believe that Latin America’s tech sector will continue to grow and many of the companies that figure out how to build sustainable, fast growing companies will drive returns over this cycle.
We expect the fundraising environment for startups to be complex for the next few quarters, but we believe our portfolio is well positioned. We won’t come out unscathed, and we expect some write offs and down rounds, consistent with the risk we take as a VC fund. We’re continuing to do the hard work with portfolio companies, having tough conversations with founders and pushing them to be more conservative about their future fundraising prospects and be more likely to control their own destinies in the current market.
For Fund 4, we continue to see more and better opportunities at Seed and Series A compared to pre-seed. We expect to see an increasing wave of deal flow in Q3/Q4 as more companies start to come back to market.
With tourist capital gone, and a higher caliber of founders starting new companies during a downturn, we are open for business, in the market, and staying disciplined to find the best founders who are building the next generation of top tier companies that can help us drive the returns we want for our LPs.
Nathan, Pedro, Mak, Francisco and the Magma team