Over the last few months, words like “downturn” and “recession” have become commonplace in describing the market outlook. At the macro level, inflation is driving central banks to raise interest rates, layoffs are becoming a near daily occurrence, and geopolitical conflict is intensifying. While the state of the global economy has certainly worsened, we expect a further deterioration in the macro. Back in April, we wrote about how this would impact the venture market and then the gaming market, and we are seeing this play out as we expected.
Although we still believe that the gaming industry as a whole is recession-resilient, gaming venture capital investment has taken a substantial hit as the broader market cooled. Rather than repeating the same bearish speculation heard from most pundits, this week we are looking backwards at objective data to better understand how deal volume and investment dollars have been impacted in the private markets of gaming.
To set the stage, it is worth highlighting that the gaming investment landscape is outperforming relative to broader venture capital:
# Deals = the number of completed and announced deals in Q3’21 and Q3’22
$ Invested = the amount invested in completed and announced deals in Q3’21 and Q3’22
The following data comes from a global analysis of Seed through Series C gaming deals on CB Insights (a market intelligence tool). Pre-Seed was intentionally left out given how infrequently these rounds are announced and the uncertain accuracy of this cohort of data as a whole. We are focusing on year-over-year data for Q3 as this is a more normalized comparison than the market peak from late 2021 to early 2022.
Across the board, investors are taking a more disciplined approach to funding startups relative to 2021. We recognize it is not hard to be more disciplined compared to 2021 given the cavalier relationship many firms have had with valuations. The bar is rising for businesses to attract capital, and this becomes increasingly true as a company progresses to each subsequent round. Every stage of financing comes with its own unique (albeit loose) expectations:
The last 12 months highlight that these expectations are malleable and can be significantly impacted by the market environment. Throughout 2021, many companies could raise multiple later-stage rounds off a compelling vision and minimal traction (often not even that). As fundamental value creation fully regains its importance in the capital raising process, more companies will fail to raise (we are already seeing this happen in the market today).
The shrinking number of deals making it to each stage can also be attributed to misaligned valuation expectations between founders and investors. Although the downward pressure on valuations is effectively a regression to the mean, the shift is making it more challenging for both parties to come to mutually agreeable terms. For some growth investors, this is killing deals just as much as their own internal hesitance in the wake of macro uncertainty. The later the stage, the longer those founders have been able to raise capital on-demand.
Q3 2022 vs Q3 2021
The below is a year-over-year breakdown of the deal volume in gaming for the third quarter:
While the general decline in gaming deal value can be heavily attributed to a reduction in the number of deals taking place, one trend to highlight is the substantial increase in total Seed funding when comparing Q3 2022 to Q3 2021. While it may seem like this spike is driven by a small number of high-value rounds, the largest Seed raise documented is actually $14.84m (we are choosing to not include Limit Break’s $200m initial raise given it is a data distorting outlier). There are two potential explanations that explain Seed’s disconnect with the rest of venture:
#1 - Early-stage venture is on a 6 to 9 month lag compared to late-stage, and the waterfall of decline across deal volume and value has not yet reached Seed. This is a position we took in April and we believe Seed is insulated for another 1-2 quarters.
#2 - Given Seed funding is not driven by business performance (but rather by team and vision), investor thresholds do not change substantially across economic cycles. Even though valuations have been compressing (we are seeing dilution tick up as investors become more conservative) and diligence processes are taking longer, Seed deals are still being done.
That being said, Seed fundraising has certainly taken a large hit compared to earlier this year. Q1 2022 ended with $462.5m in gaming venture funding, making Q3 2022 a 45.5% decline.
The below is a year-over-year breakdown of the investment value ($) in gaming for the third quarter:
Average size of gaming deals by stage is approximately a function of the two prior sections, but there is a slight discrepancy as not every announced deal included in the count discloses the raise amount.
We expect the average Seed deal size to slightly decline as fewer large rounds ($8m+) are bumping up this average. However the overall deal volume will likely remain less impacted due to the reasons that have already been discussed, so we do not expect large fluctuations.
Each subsequent stage is also likely to temporarily stagnate or decline as:
Granted, as there is a flight to quality, many of the companies that are able to attract investment are likely premium assets, so we do not necessarily expect this decline to be particularly sharp. This is a key reason it will be important not to simply look at deal count, value, or average size in isolation.
Takeaways: Gaming investment has not been immune to the global economic downturn. Despite sustained allocation at Seed, Series A and beyond has seen significant reductions across deal volume and value in the gaming investment landscape. We expect this will continue as investors seek a flight to quality and elevate their investment standards.