Venture capital financing for startups has undergone a 50% decline year over year in Q3 of 2022. While most participants in the startup ecosystem were expecting a downturn, this dramatic shrinkage in distribution is sure to send chills down the spine of many founders and financiers.
Some, such as venture capitalist Jon Sakoda, believe the downturn in funding is transitory and argue that the $ 290 billion in venture capital is “dry dust” which will reinvigorate the startup market in 2023. As a VC myself, I sincerely hope that he and others in the optimistic camp are right. However, investors and entrepreneurs need to prepare for what could be a huge level of attrition that could occur if funds were distributed more slowly.
Here are some reasons why I’m encouraging the founders to focus on their existing runway and not pin their hopes on dry dust.
VC funds will focus on their key holdings.
290 billion dollars is, objectively, a lot of money. But where it is distributed matters a lot. My impression is that VCs will reserve most of it for the more promising companies already in their portfolios.
Troubled times put investors in triage mode. Mature startups with proven business models and the potential to reach public markets within a few years will be the safest place to park any new venture capital that enters the ecosystem. The pressure to protect portfolio startups seen as potential lenders will be profound.
Beyond that lucky group, the funding situation will be less secure. The semi-finished and seed market is expected to remain relatively active, as these companies are many years away from thinking of going public. But even in the seed market, the bar could rise: I wouldn’t be surprised to see valuations go down and VCs have growing expectations of the level of traction they expect to see before funding.
Series A and B startups could be the hardest hit. Many teams that have made solid progress but continue to come up with unanswered questions about their product market suitability, market entry strategy, or total addressable market size may have a hard time increasing their next round under any conditions. As with growing companies, VCs can focus on the richest 10-20% of their portfolios. Startups that have maximized their rating in the past year or two and whose progress on key metrics hasn’t achieved that rating may have a hard time finding an eager audience.
Why doesn’t the VC market adjust to the current climate simply by lowering startups’ ratings? Unless the startup has made substantial financial progress or has developed easily valued technical resources, the “round downs” aren’t worth it for most VCs. Recapitalizing a startup requires the new investor to balance the legal rights of the existing limits table, resetting employee expectations and their own needs – it’s almost always easier to finance a new startup.
Investors need to resolve a cash flow jam.
To understand why VC funding may become more difficult to raise despite the “dry dust”, it is important to consider where the money is coming from. In his writings, Sakoda compares dry dust to a snow cover in the mountains that will eventually melt and drip to startups of all stages. While this image is a useful metaphor, it could lead one to believe that dollars are simply lying around, waiting to be linked to VCs.
The reality is more nuanced. VCs obtain their funds from pension funds, sovereign wealth funds, endowments, and family offices, among other sources. These limited partners, or LPs, manage incredibly complex portfolios and this period of upheaval creates a series of nested puzzles that they must solve to fund their commitments to VCs.
In a practical sense, LP’s cash flow comes from the liquidity received from making previous investments, which means that the money they can actually deliver to VCs depends on their other investments. Unfortunately, cash has been far less common over the past year, which could impact their balance sheets. Unrealized gains from markups are useful, but cash returns are what ultimately decide where future dollars are allocated. Added to this is the sharp decline in public market valuations, which reduces the capital they can expect to receive when lockout periods for recent releases expire. It also forces them to re-evaluate private equity models, further reducing what they expect from future proceeds. Overall, these decreases combine to create a “denominator effect” for many LPs whose risk stakes are too large relative to other asset classes. Suppose a fund aims to have 5% of its assets in venture capital. If the value of all his non-VC assets falls precipitously, he may find himself with more money committed to VC than he feels comfortable with.
Then there’s the fact that rising interest rates create other low-risk opportunities for LP’s capital. Funds may reconsider their VC commitments not only because their assets are less valuable or less liquid, but also because other investments look more promising.
The $ 290 billion could evaporate.
What if an LP suddenly feels uncomfortable with his previous engagements with VC? They can ask not to accept or “default” on their commitments. Or, they can simply tell VCs that they would prefer the money invested more slowly.
During the 2001 recession, many VC companies “returned” their capital commitments to their LPs. How B.Bill Gurley of enchmark recently noted, investors presented this as a noble act of responsibility – they were doing their LPs well. To a more critical eye, it was a gimmick that allowed VCs to start a new fund without the excess investment made in a poor year. The LPs got their money back and the VCs avoided having to explain a bad track record. Perhaps this practice will return, freeing up funds with high-performance stories to launch new vehicles while reducing the overall burden on LPs.
LPs can exercise soft power.
The above scenario is generally considered unlikely because LPs rarely default on commitments. The implication is that if the LPs do not default, the repayment of the start-up loan is a fait accompli. This assessment of the legal structure of partnerships is accurate; the waiver of the obligations towards the VCs would damage the trademarks of the LPs and would entail substantial forfeiture. However, LPs can signal to their VCs that a slower investment preference would be preferable.
While VCs may have a contractual or moral right to take sides at the agreed pace, ignoring their LPs could lead to a lack of participation in future funds. Most GPs will receive feedback from their key clients. Whether the VCs decide to distribute that $ 290 billion in two or five years makes a significant difference.
One of my company’s LPs, Patrick Cairns of Union Grove Venture Partners, explains it this way: “Companies need to raise capital to survive, but fund managers don’t need to employ capital to survive. A 10-year fund could have a 3-5 year investment period in the limited liability company agreement. Indeed, after a few years of accelerated implementation, LPs may prefer that the funds show some patience during the first part of this cycle. “
I hope my assessment of the situation is wrong. Nothing would make me happier than seeing a rapid rebound in the stock market and a revitalization of the startup rally that lasted from 2011 to 2022. Unfortunately, we must also be prepared to face a prolonged period of uncertainty.
Meanwhile, startups should reconsider their funding plans and whether they can reach profitability sooner than they might otherwise have. Nadia Boujarwah, the co-founder / CEO of Dia & Co., an emerging plus size apparel, recently reorganized her company to achieve profitability. “Getting to the point where we controlled our own destiny and no longer relied on outside investors was invigorating,” she says. “We had to make tough decisions, but they gave us the freedom to grow. I would encourage more founders to think hard about finding ways to control their own destiny. ”
In any case, the advice I’m giving to the founders in my portfolio is simple: hope dry powder, but until it materializes, strive to make the most of the resources under your control.