NFC 2023 Annual Letter Market Commentary

In this edition of Venture in the Rockies, I write to share NFC's 2023 Annual Letter market commentary. Thanks to Garrett Leach for the excellent work in researching and co-writing the letter.

The Bad, the Unknown, and the Good

In our 2022 Annual Letter, we wrote to you about the impact the late 2021 technology market selloff had on our business in 2022. We wrote…

Market-wide FOMO is gone, replaced by caution and deliberation. Focus on absolute growth at all costs is gone, replaced by an emphasis on efficiency and profitability. Institutional allocation to venture capital has slowed, with the denominator effect creating a need to reduce exposure to the asset class. And with the failure of SVB, a banking crisis has added to the volatility already impacting the technology sector and the broader economy.

These headwind themes persisted throughout 2022 until a catalytic day in November 2022 set the stage for a new chapter in the innovation economy. On November 30, 2022, OpenAI released ChatGPT to the public. It took just two months to reach 100 million users. For reference, it took seven years for the web, four years for YouTube, three years for WhatsApp, and nine months for TikTok to reach the same milestone. At the time of ChatGPT’s launch, venture was still reeling from the reset, with cautious VCs and their LPs slowing deployment, while they waited for market conditions to stabilize. ChatGPT’s launch ignited a global conversation around AI’s potential, the possibility of the next platform shift, and brought mania back to venture capital. 

Despite the optimism created by recent advances in AI, the echoes of 2022’s traumas impacted 2023 in material ways. Institutional Limited Partners remained cautious when making allocations to new venture managers, non-AI companies were held to high standards for growth and efficiency, exits remained scarce, and macroeconomic and geopolitical uncertainty served to temper overall optimism. The title of our 2023 Annual Letter captures these mixed circumstances, The Bad, The Unknown, and the Good.

The Bad

The primary challenge of 2023 related to capital supply in venture capital markets, especially at the early-stage. As you can see in figure one below, 2021 and 2022 saw unprecedented investment into private US early-stage technology companies. Relative to the expected growth rate in investment from the prior five years, in excess of $50 billion of additional investment went into early-stage venture companies. This excess had significant implications for pricing and round sizes, which proved to be a challenge for the Firm given our discipline on entry price. 

At the Series Seed, median pre-money and median round size are up 69% and 75%, respectively, since 2019, to $11.0M and $2.9M. Seed data from former NFC portfolio company Aumni is even more striking, listing median Series Seed round sizes and post money valuations over the past three years in software companies at $3.7M and $20.0M. At the Series A, median pre-money and median round size have increased 75% and 57% over the same period, to $35.0M and $12.6M. Additionally, we have seen many of the coastal venture funds active in our region.  For multi-billion dollar large coastal funds, the Seed round functions as a call option on breakout possibilities. Moreover, they are often willing to accept lower ownership and control at entry, content to wait to exercise the option with additional capital in size in the event a company breaks out. Traditional venture capital fund math shows why this behavior, big multi-stage funds indexing at the early-stages, makes sense. 

A $2B fund must generate at least $6.5B in returns to distribute 3x net to Limited Partners. Owning 15% at exit, that $2B fund must invest in companies which are worth over $40B at exit. This dynamic has resulted in these funds making scattershot Seed investments in anything that looks like it has a shot at becoming a decacorn before any product is created or revenue generated. VC data science teams are mining founder archetypes, veterans from Alphabet, Meta, OpenAI, etc, and preemptively issuing term sheets based more on founder archetype and sector than on fundamentals. NFC bowed out of a material number of investments throughout 2023 where this dynamic led us to believe the risk/reward at entry was not acceptable. This discipline on entry price is one of the reasons Fund IV’s deployment pace was slower than we would have expected. 

It is unclear if this excess capital supply dynamic will resolve itself within the investment period of NFC Fund IV. It will likely take at least two more years for the excess capital raised by venture funds throughout 2021 and 2022 to be deployed. The unknown variable here is fundraising. If Limited Partners begin to make significant allocations to venture capital again, this could be a perennial dynamic at the early-stages, likely further driving up valuations and round sizes, with the potential to depress returns. 

With respect to fundraising, LP allocations to venture fell precipitously in 2023 from record highs set in 2021. However, even with LP allocations down over 50 percent from 2021 levels, US venture funds still raised as much in 2023 as they did in the years immediately preceding the pandemic. This is evidence of both the extreme excess of capital deployed into venture during the 2021 exuberance and the long-term commitment Limited Partners have to the asset class. 

Fortunately, the fundraising picture looks different when considering only US funds investing in early-stage companies (Pre-Seed through Series B). For those funds, capital raised is down not just from 2021 records but also relative to pre-pandemic levels. As shown in Figure three below, deal count and capital raised for these funds is down 82 and 81 percent, respectively, from 2021 levels, and down 70 and 45 percent, respectively, from 2016 levels. Fundraising for regional firms was also challenging in 2023, with only $600 million raised by Rocky Mountain Venture Firms, down from $4.7 billion in 2021. 

The slowdown in venture fundraising dynamics may serve to balance the capital supply demand imbalance which has persisted the past two years and to ease one source of competitive pressure at the early-stages of venture. Firms able to raise fresh vehicles at target size, such as NFC with Fund IV, will be well positioned to capitalize.

The Unknown

Macroeconomic and geopolitical uncertainty remains heightened, and serves to temper optimism in our markets. Although it appears the Federal Reserve may have normalized monetary conditions without tipping the US economy into a recession, inflation is still running above target and remains a risk and robust fiscal support has served to support the economy throughout the Fed’s hiking cycle. Global geopolitical uncertainty provides another short to medium term risk to robust growth, and any kinetic conflict, especially heightened tensions between the US and China, could severely disrupt energy and technology supply chains, which could hamper economies around the world.

Also still unknown is how the capital supply imbalance will resolve in early-stage venture. Given our Fund size, we face an upper bound to our initial investment size in order to keep the number of companies in the Fund above our target number. If early-stage venture capital supply remains elevated with coastal mega funds investing significant amounts into Seed companies across our region, we will need to be more creative in order to win lead positions in companies which fit our target archetype, while maintaining discipline on entry price and terms.

We have also shared with you our belief that as this excess venture capital raised in the 2021 - 2022 period was invested, the early-stage market would find an equilibrium for prices closer to levels we believe are rational. The latest data confirm no reset has occurred yet, with Carta recently reporting median pre-money valuations for priced Seed and Series A rounds are near all time highs.

The liquidity environment also remains tenuous. There were only two notable non-biotech VC backed IPOs in 2023. Instacart went public at a $9.9B valuation in September, down nearly 75 percent from its last private funding round. Just a day later, Klaviyo started trading at a $9.2B valuation. Reception of these two deals provided some hope of revival in the moribund venture backed IPO market. Two IPOs in early 2024 have provided more evidence of investor optimism. Astera Labs, the California chip firm, sold stock at $36 per share in late March before trading up to $70 per share in early April, giving it a market cap of over $10B, and Reddit, the social media site founded in 2005, went public just a day later, and now trades at a market cap of $7.7B. 

Pitchbook’s latest release of its quarterly Venture Monitor report highlights the collapse of liquidity for VC backed companies following 2021 mania. The number of exits in 2023 was down 38 percent from 2021, and the value of exits was down a shocking 84 percent. The prevailing narrative among venture capitalists and the press is that liquidity is close to impossible to find, which is true at 2021 valuations. Exits are still happening - relative to 2019, the number of exits in 2023 was up 1.3 percent - but exit value was down 36 percent over the same period, highlighting the reset in prices acquirers are willing to pay. This data highlights there are still paths to exit and liquidity for companies and their investors, but at valuations that don’t come close to those available in 2021. In this liquidity environment, we will continue to search for companies which have several viable paths to liquidity, with a particular focus on strategic M&A as the primary path to exit. Fund II’s exit of Aumni through a trade sale to JP Morgan is a good example of this underwriting.

The Good

Anecdotal evidence from the late 2021 and 2022 period would have suggested venture markets were frozen, with founders only being able to raise on investor friendly terms, investors taking months to do due diligence, and many companies simply unable to raise at all. Now that data is in, it’s obvious that was a distorted picture. While invested capital and deal counts are down from mania period highs, at the early-stages down 39% and 26%, respectively, relative to pre-covid the 2023 numbers appear inline with prior trend growth, up 37% and 17% over 2019. The same trend holds true when considering all of US Venture, early-stage and later-stage. 

Early-stage venture markets never really closed for business, and are now re-energized by several themes which could be boons for future returns. First is artificial intelligence. The launch of ChatGPT in November of 2022 brought the potential power of artificial intelligence into the public consciousness and resulted in investors piling into the most promising names building the foundation technologies that will support this potential platform shift. Eye popping valuations abound in the private markets - OpenAI is worth $86 billion, Anthropic $18 billion, Inflection $4 billion, Mistral $2 billion - and the ‘magnificent seven,’ Nvidia, Meta, Amazon, Microsoft, Alphabet, Apple and Tesla, added trillions of dollars in market cap. AI companies can command striking valuations because the rewards to winners of this potential platform shift could be extraordinary, and for venture capitalists, the price for missing could be enormous. Capital raises for these companies are substantial because the compute requirements to train foundation models means scaling a new AI company costs multiples more than with prior generation SaaS companies. Sam Altman, the CEO of OpenAI, has estimated that it took thousands of chips and over $100 million to train one of the company’s latest models, GPT-4.

Importantly, in prior technology platform disruptions, advantage often accrued to new entrants at the cost of incumbents, the innovator's dilemma. For example, the move from mainframes to distributed computing, client server to cloud, the rise of search, mobile, all allowed for new entrants to disrupt incumbents and win the new platform wars. Given the massive capital expenditures required to train AI models, incumbents may well prove to be the winners in the AI disruption. Given the giant increase in market capitalizations of the mega-cap companies since November 2022, the market believes incumbents will massively benefit from AI.

Artificial intelligence has the potential to reshape our lives in many ways, some unsurprising, such as better customer service bots, and many transformational, including as a tool to discover novel medications, reshape the way wars are fought, and potentially power the next step change in economic productivity. NFC has been investing in companies building AI powered solutions since 2015, first with Fund I’s Quiq, which builds AI for customer service teams, next with Fund II’s TwinThread, creating cloud-native industrial optimization software powered by AI, and then with Fund III’s mpathic, a conversational AI platform for healthcare, software, and other industries. We will continue to mine our market for companies leveraging the massive capital expenditures, models, and datasets made available by technology platforms to power innovation and applications to improve productivity and efficiency, while avoiding business models that require ten-figure investments to compete.

Figure six below outlines periods in US history where technology advancements, measured by total factor productivity growth, the portion of economic growth unaccounted for by the factors of production, drove robust economic growth. Throughout the 1920s, 1930s, and 1940s as the country electrified and combustion engines drove a step change in the efficiency of transportation and commerce TFP growth was between two and three percent. In the early 2000s advances in information technology including the development of the world wide web drove gains in TFP of around one and a half percent per year. In recent years, TFP growth has slowed, especially concerning for overall economic growth when considered alongside stagnant growth in the US labor force. As Ken Griffin noted in his 2023 annual letter, “We must stop borrowing at the expense of future generations. The Western world urgently needs a significant increase in productivity growth as the burden of rising government debt and entitlement spending strains almost every major economy.” Artificial Intelligence raises the possibility it is a transformational general purpose technology that could drive TFP growth rates to levels not seen in five decades. 

For example, Microsoft CEO Satya Nadella recently noted its development teams are now 50% more productive when using Microsoft Copilot, its generative AI solution which can write code, create PowerPoint presentations, and craft Word documents on your existing data. This step change in engineering capacity will create pressure on other functions inside organizations to adopt new processes, design, and technologies in order to adapt to the new cadence engineering teams can now deliver on.

The geopolitical environment is also tenuous, with war in Ukraine, Israel, and competition with China each increasing the likelihood the US is drawn into major conflicts. These tensions have catalyzed the creation of a new generation of venture backed companies building hardware and software for the US Military and its allies. The nature of war is changing at a rapid clip and the prior generation of defense contractors has been unable to deliver the necessary capabilities to our troops in a timely fashion, especially related to software and edge compute requirements. Andruil is the most public success in this class, becoming a decacorn in under a decade, but many opportunities exist to back founders building exciting capabilities for defense. NFC has invested in dual use companies in the past, Fund II’s S2 Corporation and Fund III’s BioSqueeze, and Fund IV is about to close an investment in an exciting DefenseTech company building software to enable better decision making for operators at the tactical edge. 

The artificial intelligence boom is also driving an insatiable demand for power, putting additional stress on US and Global grids already straining to provide enough stable power. Grid Strategies, a power consulting firm, stated in December that grid planners recently doubled their five year load forecasts, expecting an additional 38 gigawatts of demand over this period, also noting this is likely an underestimate of near term demand growth. Figure seven below, a slide created by Michael Cembalest of J.P. Morgan Asset and Wealth Management, illustrates this demand increase being almost solely attributable to data center power consumption.

Energy companies are being held to high standards for efficiency and sustainability while delivering necessary levels of supply, and NFC has several investments which assist these firms meeting that need. Bridger Photonics, NFC III, delivers information to energy companies gathered by an aerial deployed LiDAR sensor to identify and measure methane leaks in companies’ infrastructure. BioSqueeze, NFC III, is delivering a novel material solution to assist oil and gas companies plugging old wells and to control casing head pressure in actively producing wells as a method to extend their useful lives. King Energy, NFC III, is developing solar arrays on multi-tenant commercial and industrial buildings, and writing software to enable building tenants to share the financial benefits. Venture backed companies are working to solve various grid and energy related challenges, from software to optimize demand planning to new classes of nuclear power plants. NFC continues to source exciting companies across the Rockies creating solutions to tackle the world’s energy conundrum. 

Our firm is also positioned more favorably than at the end of 2022 when we last wrote to you. With offices in Boulder, Salt Lake City, and Bozeman, we have a boots on the ground presence in each of our core markets, giving us an information advantage relative to other regional and national firms. We are currently adding additional human capacity, including a Principal to sit with GP Kirsten Suddath in our Boulder office, and will hire an Associate to work with Franz Kofler in Salt Lake City later this year. And the regional tailwinds creating ample opportunities to invest across the Rocky Mountains are still robust, with exceptional talent moving to the region to build companies of global impact, many looking for a local venture partner to do so. 

In conclusion, 2023 was a positive year. Tailwinds are driving ample opportunities to invest in exciting defense, artificial intelligence, and deeptech companies. Fund IV is close to target size with a strong pipeline of companies. Venture is increasingly competitive and for NFC to win lead positions in the best companies against large coastal funds and our regional peers, we must employ creative strategies to find founders earlier on their journeys in order to win their trust and confidence in advance of fundraising, while maintaining discipline in the face of a market that remains frothy. Early investments in Fund IV, 401GO and VirtualZ, and others near close suggest we have a team which can prosecute that mission with discipline, patience, and focus with differentiated deal sourcing that will lead to high potential investments riding these powerful waves of innovation.