Magma LPs,
Q2 seemed like we might be turning a corner in the markets. There’s still going to be lots of pain in the second half of the year and into next year. Many later stage companies still need to reset. The bar for raising money is still very high, but we’re seeing signs of life in the market.
For example, US funds that invested money into Latin America in 2020/2021 and were completely out of Latin America in 2023 started to reach out in Q2. They’re not funding startups in big numbers yet, but they are kicking the tires again.
More Series As are happening again, but hardly any at premium valuations. Some investors are feeling FOMO again, even outside of A, with a few powerpoint startups raising $10M+. These deals are the rare exception, but they are happening again. There were basically none in 2023.
We don’t expect 2021 again, but the market is slowly improving. Even with the bright spots, it's still very hard for all but the best companies to raise their next round of funding. Many later stage companies still have not raised since 2021. Anecdotally, it seems like Magma’s portfolio has reset more slowly than other funds. ~33% of our portfolio companies that raised $20M+ in the 2021 boom have reset, whereas that number might be closer to 70% in other funds we’ve talked to.
The companies that haven’t reset fit into three buckets:
It feels like most of our portfolio companies that haven’t reset are in buckets 1 and 2. Those that did reset either raised at lower valuations (down rounds) or maintained their valuations by agreeing to structured terms like multiple liquidation preferences or draconian pay to play terms that rewarded funds that invested new money into the restructuring and punished investors who did not with up to 95% dilution.
Distribution of US VC-Backed Tech Companies by Runway
This chart shows that the percentage of VC-backed companies with 12 months or less of runway reached 55% in Q2 2024, up from 38% in Q2 2021. These companies with less than 12 months of runway are still going through the slow motion car crash. Some of the companies with longer runway have already reset, a few others might be zombies.
Fewer companies are growing quickly. The chart below shows that ~25% of venture backed companies are growing faster than 50% per year, down from nearly 55% in 2021. Some are growing more slowly, but they now have healthy unit economics. Others got stuck and aren't growing. During the boom you needed to be growing at least 2x per year to raise a Series A. Now, 70% growth puts you in the investible category, and SaaS companies with $10M+ revenue growing at 50% can raise significant money.
Distribution of Growth Rates for US VC-Backed Tech Companies
Paradoxically, Silicon Valley Bank’s recent data showed that companies with 12 months or less runway grew more quickly. We don’t know if this is causation or correlation, but anecdotally, the companies that had more constraints generally have grown more. These could be companies that never raised capital and had to be efficient from day 1, or companies that raised huge rounds, but once they confronted the abyss of 12 months of runway or less, they got focused and grew more quickly.
This image from Crunchbase in 2019 shows what a typical VC fund’s returns look like:
VC fund internal rate of return (IRR) and Total Value to Paid in Capital (TVPI) starts out negative and then increases over time. J curves happen because funds have expenses, startup costs and management fees and investments haven’t raised follow-on rounds during the first 1-2 years since inception.
But during 2020-2022, funds sometimes had huge paper markups in year 1 or 2 which eliminated the downward part of the J Curve. There were even articles breathlessly touting The Death of the J Curve.
These articles had all sorts of reasons for why the J curve was dead, other than the reality: VCs were investing much more quickly, marking up companies regardless of their underlying fundamentals. Pre-seed companies were raising like Series A companies and Seed companies were raising $50M-100M Series B rounds.
VCs raised new funds on the back of these quick markups. As valuations have reset, many of these paper markups retreated back to normal and the J curve is back. Lux Capital’s Josh Wolfe thinks that many new funds from the boom will not be able to raise new funds: "the vast majority of new participants engage in what amounts to a financial fool's errand. We continue to expect the extinction of as many as 30-50% of VC firms.”
TVPI by Vintage Year | Vintage years 2017-2022 | 25th, Median and 75th percentiles | Data as of Q1 2024
Unrealized IRR by Vintage Year | Vintage years 2017-2022 | 25th, Median and 75th percentiles | Data as of Q1 2024
Take all of these TVPI and IRR comparisons with a grain of salt: different funds mark down overvalued portfolio companies and mark up companies using very different methodologies.
Another grain of salt: lots of data suggests that these quartile ratings don’t mean much until year 5 or 6.
A third grain of salt: IRRs are wildly misleading in the first few years of funds, but become more significant as funds age.
Why is the J Curve back? Because graduation rates from Seed to Series A and Series A to Series B have slowed down, meaning that our earliest investments are not raising follow on rounds as quickly, even if they’re doing well.
The J Curve is making it harder for first and second time funds to raise fund 2 or fund 3. They have less to show, even if the underlying numbers after looking at TVPI are actually good, so LPs are pumping cash into the biggest names: LPs invested 50% of all VC dollars into the two largest funds!
Percent of seed-stage startups that graduated to Series A by cohort of seed fundraise | Q1 2018-Q2 2022
This chart shows the slowdown in graduation rates from Seed to Series A. At the peak of the boom (2021), 30% of startups raised a Series A within 5 quarters of their Seed. A year later, it’s taking 11 quarters for the same 30% to graduate from Seed to Series A.
40% of seed startups raised their Series A within 8 quarters at the peak of the bubble, up from 25% before the boom. Only 15% of startups that raised their Seed in Q1 2022 have raised their Series A 8 quarters later, and Q2 2022 looks like it’ll be even lower after 8 quarters.
We expect current trends to continue:
The secondary market is where existing investors sell shares to new investors to turn paper into cash. The market was mostly closed in late 2022 and 2023, but has boomed in 2024. While the US is booming, most US secondary buyers are not willing or able to diligence the Latin American market, which makes it a buyers market.
US Secondary Fundraising Indexed to 100 in 2017
Secondaries are hard. Many founders don’t like sellers, and it’s nearly impossible to get good data if you’re not already an investor. We think that secondaries will continue to get normalized in Latin America, but will take longer than the US market to fully recover, making them an interesting opportunity we’re watching.
SaaS companies in Latin America have it hard. Many struggle to reach scale, or $10M+ Annual Recurring Revenue (ARR). Latin America’s market is smaller, customers pay less, and incentives make it hard to reach $10M+ ARR. Magma’s Laura Martinez wrote a series of articles about how we think about SaaS in Latin America.
One of the theses we’ve been investing in since we started 10 years ago is vertical SaaS: expand SaaS by embedding payments, lending, insurance, and potentially ecommerce.
Our thesis is: it’s really hard to get a Latin American company to pay you for a high enough percentage of the value you create simply with SaaS. You might get stuck charging $20/month when you’re creating $500/month of value, and when you try to raise prices to $100/month, your clients churn. You might face global competitors or local champions.
One of the ways to increase your take rate is by adding new revenue streams like payments, lending, insurance and ecommerce. Embedded finance has been a buzzword in the US, but really hasn’t materialized to match the hype. Matrix’s Matt Brown has been writing great articles on this opportunity and showed that many embedded finance companies only add payments and nothing more, even if it’s low hanging fruit.
In his newest article, invisible asymptotes in vertical software, Brown explains the case for changes in Vertical SaaS. His TL;DR is:
Brown’s thesis resonates with us because we’ve been deploying capital into operating system and vertical SaaS businesses since Fund 2.
We believe that this opportunity is even bigger in Latin America, as there’s less competition, more opportunities in payments, low insurance penetration rates and opportunities to lend to clients or even sell them products. This way, Latin American companies can go from $20/month to as much as $500/month of the value they’re creating, be more sticky, and actually solve real problems.
Taken to its extreme, founders might be better off buying traditional businesses and operating them using their operating systems, rather than simply selling the software and payments to others. From the article:
The idea is that rather than sell software and services to businesses, you actually own the businesses and operate them more effectively with proprietary tools. This is best articulated by Slow Ventures’ excellent “growth buyouts” thesis, which is worth a read. The idea is that the ideal way to monetize certain verticals is to build vertical software that gives you an edge in that market, buy an operating company, apply that product to the company to help it grow, and then repeat.
This thesis is compelling for Latin America. You sometimes need to get into the real world to actually make a difference, build out the infrastructure, or simply buy the business.
We expect the previous stark delineation between the real world and the tech world to get more blurry as more AI-enabled vertical software that combines payments, lending, insurance, ecommerce and more become more common. Founders may make the decision to move from software as a service to software and service, to simply running business more profitably with their own internal operating systems.
We are excited about the new opportunities we are seeing, especially so far in 2024. As AI becomes table stakes for new companies, it’s allowing founders to build more, sell more and be more efficient with the capital we invest, especially at pre-seed and seed.
When we mix new AI advances with the high quality founders who learned their lessons during the boom, we get really excited. We’re seeing lower entry points, better founders, better dealflow, fewer competing VC funds and fewer tourist founders.
We are seeing early stage companies stretch their investment dollars farther, meaning they have more traction and can raise with lower dilution, if they even decide to raise again. These companies don’t need to be high-end AI-only companies. They can match an efficiency-minded founder with AI tools to potentially create bigger companies at much lower costs and dilution.
We continue to be bullish on Latin America’s best entrepreneurs solving Latin America’s biggest problems.
Best,
Nathan, Pedro, Mak, Francisco and the Magma team
