- Capital Call by OneFund
- Q1 VC Update and Taxes
Q1 VC Update and Taxes
A bi-weekly newsletter from LPs for LPs, covering the latest and greatest from across the private markets
Calling all LPs!
Welcome back and thanks for joining me (John Bailey, Co-Founder at OneFund) for the fourth edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs.
This week I cover:
EY’s Latest Q1 Venture Capital Update
Qualified Small Business Stock (QSBS) Tax Exemptions
The Latest Insights From Leading GPs.
If you are a new subscriber, make sure to check out our most recent newsletter in which I share some insights from Pitchbook’s Global Fund Performance Report.
Subscribe now and stay ahead of the curve with OneFund.
Q1 Venture Capital Update: Quarterly Rebound, but Headwinds to Persist
Venture Capital financing has continued suffering throughout the past few quarters, but 2023 Q1 results show VC-backed companies raised $44.1b, a 37% increase from the previous quarter, according to EY’s latest report. Though a sizeable quarterly improvement, the main headwinds of economic uncertainty, bank failures, and a dampened investment mood (especially at the early stage) persist. This is especially seen in fund formation, which is down to just $13b in Q1 2023 compared to $78b in Q1 2022.
EY, and many other experts, predict 2023 investment levels to drop off from 2021 and 2022 levels, but there are still opportunities to make smart investments. In this week’s newsletter, I’ll dive into the themes within EY’s Venture Capital report and what matters most to prospective and existing LPs.
Investor-Friendly Capital Deployment
GPs are changing their investment strategy to adapt to the current environment, and LPs should take note. VCs still have significant capital to deploy, but are being more selective and are often focusing on existing, winning portfolio companies rather than Seed or Series A rounds. Entrepreneurs looking for funding are having to prove a reliable path to profitability with strong unit economics and realistic growth projections rather than pitching ambitious, idealistic growth visions.
LPs who invested years ago targeting aggressive return characteristics should now consider if current VCs’ more conservative approach still matches their desired portfolio goals.
IT Remains Strong while Consumer Goods Falters
IT constituted 42% of investment value in Q1 2023, followed by 26% for business services and 17% for health sciences. LPs should expect IT to remain strong as companies continue to innovate through cloud, generative AI, and other service infrastructure, not to mention the solidification of remote work.
On the other hand, consumer goods have declined 32% to merely 3% of investment value. EY expects this trend to continue until inflation and interest rates stabilize.
These figures shouldn’t distract LPs though. Successful companies will eventually emerge out of every sector and investors should still focus on promising entrepreneurs, business fundamentals, and finding good funds rather than headlines.
Regional Dispersion Reverses
Except for San Francisco, most regions experienced a significant drop-off in investment from last year. This is a reversal of the geographic dispersion trend set by the pandemic, where VCs bolstered investment in secondary cities such as Denver, Austin, and Phoenix. As VCs have become more selective due to economic uncertainty, they’ve flocked back to the familiar Bay Area ecosystem that has given them historically strong returns rather than venture out to other geographies.
LPs should consider that this may present more opportunities for outsized venture returns in secondary markets. With fewer VCs competing for deals in these markets, deal metrics and fundamentals may become more favorable. LPs can gain exposure through VCs with strong secondary offices, or VCs native to outside regions.
Qualified Small Business Stock (QSBS) Tax Exemptions & What It Means for LPs
A relatively unknown tax incentive every private market investor should be aware of is Qualified Small Business Stock (QSBS), which can lead to full tax exemptions on capital gains. QSBS aims to spur investment in startups and allows exemption from federal & 43 states’ capital gains tax, alternative minimum tax (AMT), and net investment income tax (NIIT). It allows the exclusion of up to $10m or 10x the basis of the investment. There are several criteria needed to qualify for QSBS tax exemptions, but QSBSexpert.com outlines the key qualifiers:
The company must be a Domestic (United States) C-Corporation and have their assets/focus be in a qualified industry (software companies seem to check the box most of the time)
The company must be smaller than $50M in gross assets immediately after stock issuance and the stock must be purchased from the company directly
You need to hold the stock for at least five years. If you don’t hold the stock for five years, you become eligible for a 1045 exchange, which is a similar concept to a 1031 exchange in real estate
An example given is a Georgia VC with 10 LPs that invests in qualifying QSBSs and realizes a gain of $100m. Assuming equal ownership, each LP gains $10m and would owe nearly $3m in tax (20% Federal capital gains, 3.8% NIIT, and 6% Georgia capital gains), but the QSBS incentive reduces the tax to zero. This significantly impacts the post-tax return for these hypothetical investors
LPs diligencing funds should actively ask about QSBS to ensure that funds that can do so are taking advantage of the tax credits. Prospective LPs should consult a tax professional before making decisions.
Our team just wrote an in-depth blog article on the topic so make sure to give it a read: here
If you enjoyed this read and have any questions or would like to discuss further, feel free to schedule a call with us - we’re happy to chat.
Updates from Across the Ecosystem
Jon Gray, President of Blackstone, states inflation is in the “rearview mirror” in his latest quarterly update. Gray mentions shipping costs have reversed to nearly 2019 levels and U.S. wage growth has slowed from 7% last year to 5.6%. He predicts the Fed won’t lower rates as quickly as the market expects, but the market pressure of rate hikes should go away soon.
Bessemer shares their updated “fundability benchmarks” for the current financing market. LPs can see that fund managers like BVP aren’t looking for TAM, vision, and market dominance anymore. Instead, they want levelheaded founders that provide a realistic growth plan.
Sam Korus, ARK Invest
Sam Korus, a director at ARK Invest, provides a useful chart depicting the implied growth rates of a 15-year S-Curve. The S-Curve is a widely used framework in VC for forecasting revenue growth as product adoption goes from zero to one in the shape of an S.
Startups should target 100%+ revenue growth early in the curve from years 0-5 but see declining growth thereafter. LPs should remember that growth rate declines can be healthy progression on the S-curve as the company matures rather than a fundamental business issue. This provides useful context on the revenue growth targets shown above by BVP.
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