Last year was challenging for the tech industry. Tech companies underperformed after going public amidst a scenario of overall public market declines, geopolitical issues and war, high inflation, interest rate increases, supply-chain disruptions and economic uncertainty. And if that wasn’t enough, layoffs across the tech sector became the norm as companies had grown faster than their businesses could sustain and funding became more difficult to come by.
Despite the overall declines in the tech industry, Texas startups, while not unscathed, have continued to raise capital.
Austin-based startups, for instance, raised almost $5 billion in venture capital in 2022. While this is slightly down from the $5.4 billion raised in 2021, it is still a huge jump from slightly more than $2 billion raised in 2020, according to a report from Austin Chamber/Opportunity Austin. Austin startups are now valued at $128 billion, a record high.
Dallas-based startups, meanwhile, raised a little over $3.2 billion in 2022, just under the $3.7 billion raised the previous year but well over the $2 billion raised in 2020, according to data from CB Insights. Deal activity has remained stable, with 178 deals in 2022 compared to 177 deals in 2021.
In Houston, VC investors poured about $1.8 billion into 180 deals, down from almost $2.1 billion in 222 deals, according to PitchBook data.
The capital raised by startups in Texas, like in other geographic areas, came with lower valuations (even some of the dreaded “down rounds”), equity sweeteners like warrants and more “structure” than in recent years. Investors began requiring terms that were more favorable to them, including tranched closings (where funding is conditioned on milestones), valuation adjustments based on milestones (to bridge disconnects in valuation between companies and investors), hurdle or return rates, increased liquidation preferences, participating preferred provisions (where investors get back their investment plus an additional amount, and/or participate with common stock as if they had converted to common stock) and increased control rights.
Despite the decline in capital raised by startups and the more stringent deal terms, deal activity is expected to continue, as VC funds are flush with dry powder from record-high fundraising in 2022. After all, great startups are made even in a downturn, and VC funds will have to put their money to work.
In Austin, hopeful startup founders will flock to SXSW this week to participate in the festival’s annual pitch competition to try to garner investors’ attention. After all, almost 600 companies that participated in the competition between 2009 and 2022 received combined funding of almost $21.5 billion, not including undisclosed grants, angel and seed funding, according to SXSW.
During SXSW, and in general, startups in growing sectors such as clean energy and electric vehicles are more likely to get investors’ attention, not only thanks to the business opportunities seen in combating climate change, energy independence and ESG but also from related public policies such as the Bipartisan Infrastructure Law and the Inflation Reduction Act, which incentivize investments in these sectors.
In addition, corporate investors, with their technical expertise, know-how, and marketing and distribution channels, are providing support for startups beyond cash to fund external innovation.
Fawning popular attention to open tools like ChatGPT also has turned a spotlight on ventures promising new applications of artificial intelligence and machine learning. Fintech, blockchain and cryptocurrency companies and their investors are seeing opportunities for growth and funding after a tumultuous 2022. Data and analytics and security technologies continue to see support as information and cybersecurity needs for businesses grow more complex. Advanced connectivity, supply chain/logistics and mobility technologies are some of the additional sectors where we anticipate continued growth opportunities.
So what does it take for startups to increase their chances of raising capital in a turbulent market? Besides having a unique insight to solve a big problem in an important market, startups must also show they have the team most capable of executing their vision, a plan to market themselves, a credible proposal for how much capital they will need to invest to acquire a sufficient customer base and a strategy of how to grow and monetize it. And traction is critical to show validation of the idea and the business.
VC investors will also favor startups that have developed unique intellectual property and are making sure it is protected. According to PitchBook, startups seeking patents raise more capital than their non-patent-seeking peers. About 58 percent of venture capital went to startups with patents or with patent applications, it adds.
PitchBook data also shows that across stages, startups that have patents or have applied for them “raise capital at notably higher valuations than non-patent companies. Angel deals show the largest difference (the annual median is 93.2 percent larger on average), and late-stage deals clock the second-highest figure (the annual median is 51.2 percent larger on average).”
While the time between filing for a patent and having it granted can take years, the U.S. Patent and Trademark Office offers a prioritized examination program in which companies can have a patent granted in a matter of just a few months. While there is a fee attached to this, startups might consider it a sound investment, as it could mean they can already have their innovations patented by the time they begin courting investors.
It is impossible to predict how or when the market will stabilize, but we do expect startups that have innovative and practical products and a solid go-to-market plan to get funded.
Michael Torosian is a partner in Baker Botts’ corporate department.
Christopher Palermo is a partner in Baker Botts’ intellectual property department.
