Minnesota startups will likely see another rocky year for venture funding

Venture capital fund managers anticipate being more selective on deals this year, a warning to cash-strapped Minnesota startups that it will be another tough period to find needed dollars.

Both the number of deals and amount of venture funding streaming into Minnesota companies both already dropped about 16% last year, according to the National Venture Capital Association and PitchBook, a tracker of investment deals.

Still, Minnesota startups collected $2.17 billion in funding, down from the record $2.6 billion in 2021. Nationally, venture capital funding for startups was down nearly 31% to $238.3 billion.

The reason? Investors were reacting to speculation of a recession, and the value of investor-backed companies dropped amid an economic downturn, local investors said.

Adam Choe — managing partner of Tundra Ventures, a $10 million venture fund in Minneapolis — compared the state of venture deals to the housing market the past two years. The homes on the market were priced quite a bit above their value just a few years prior.

"No one can afford to buy or leave," he said. "Everyone is locked into their homes. Companies are locked in those valuations."

As a result, money may be harder to come by for entrepreneurs looking to raise large sums in 2023, with investors more concerned about a company's execution and traction in the market, Choe said.

Investors are now cautious of high-valued companies seeking large sums of money to stay afloat — particularly those trying to move past their Series B and Series C rounds of funding, which are typically companies that have survived the initial startup phase and have met certain milestones to appease their first investors.

"Valuations have declined slightly in seed stage but more aggressively in Series A or B rounds, especially for companies that have lower margins or are very capital-intensive and will require additional rounds of funding before becoming profitable," said Rob Weber, co-founder of Great North Ventures, another Minneapolis venture fund.

Series A investors often want to see valuations between 10 and 15 times the annual recurring revenue, Weber said. In 2021, investors were seeing company leaders raising money as high as 30 times their annual recurring revenue.

"If you are a startup founder looking at historical data, you need to wipe out the second half of 2020 and most of 2021, and put that in the rear-view mirror," said Choe said. "We printed trillions of dollars, and people were looking ... to put that money in places that were freely available. Oftentimes, what ended up happening was investing in startups, throwing darts at the wall at high valuations, without much oversight or second-guessing because the capital was just flowing."

Others agree.

"It's no longer a founder's market," said Reed Robinson, founder and partner of Groove Capital, a Minneapolis early-stage firm that's raising $15 million for its second fund. "It's an investor's market. It's going to be harder for them to raise money because they don't have as much leverage."

There are upsides to 2023, investors said. Committed capital from investors isn't going anywhere, and companies that raise at seed levels this year likely won't have the immense pressure of generating unattainable metrics to get favorable valuations.

Meanwhile, an economic downturn would create opportunities for early-stage investors, as executives and technologists laid off by larger employers start their own companies.

"We think this is going to be some of the best conditions we'll have in a market for the foreseeable future," Robinson said. "We have the patience to wait out what's happening on a macro level."