Venture Capital has traditionally played a crucial role during recessions by nurturing innovative technologies in the face of cutbacks. Things look a little different this time.
During a recession, venture capital has traditionally played a crucial role in helping sustain tech companies. The forces shaping this economy, though, are unique. Venture capital’s role is less certain as a result.
The Traditional Role of Venture Capital
Economic downturns often lead to absences in the marketplace. These provide opportunities for tech-forward entrepreneurs.
We saw it most recently with COVID-19 when organizations were forced to rethink their operations. As business models became untenable technology companies stepped in to bridge the gap.
During the great recession of 2008 start-up activity driven by new technologies surged. Nationally, more than 550,000 new businesses launched in 2009 and indexes of entrepreneurship rose as well.
We can expect a similar burst of entrepreneurship and funding with this economic slowdown, but getting there will be complicated.
It’s Different This Time
The tech industry has been particularly impacted by the most recent market crash. The need to do more with less driven by a sector-wide belt tightening is usually a good thing for tech. Now, problems just below the surface in the venture markets may hamstring tech companies this time around.
There’s actually a record amount of VC funds getting raised right now. In July it was reported that VC funds in the US have already closed $137.5 billion, just shy of 2021’s full-year total of $142.1 billion.
However, most of the funds are being raised by mega firms like Lightspeed, Battery Ventures and Oak HC/FT. In this sense it’s a unique market in that there is a record amount of venture capital out there, but, most of that money is bunched at the top. This has a tremendous impact on how and where venture money is deployed.
Mega-firms behave and invest very differently from the other VCs. They tend to invest almost exclusively in the top percentile of startups that are growing at the fastest rate.
The concentration of funds at the top of the venture funnel means more money will go to fewer startups. This leads to a bifurcation in valuations between top performing companies and their slower growing counterparts. Truth is, there are only so many potential decacorns to go around and, recession or not, venture funds have to deploy.
This begs the question: if the mega funds pile into the same number of winners, how much will those company valuations really fall? If the past twelve months have taught us anything it’s that the public markets don’t have much sympathy for what the VCs paid before them.
Normally an abundance of capital indicates a coming surge in start-up activity. But the combination of economic compression and consolidation of capital means that VC firms further down the funding funnel will likely experience more difficulty raising from new LPs. This makes them less likely to invest in new unproven Seed and Series A founders. They’ll place their bets on select, proven CEOs with stronger backgrounds instead.
They will also need to increase their reserves to protect the more promising investments in their own portfolios as the bar for future fundraises gets higher and try to ensure enough runway to sustain themselves through lean times.
The bunching of funds at the top of the venture funnel also means more money will go to fewer startups and later stage venture-backed entities. This necessarily dilutes the field of opportunity for Series A and seed-round startups.
VC firms further down the funding funnel will be less likely to invest in a wide array of seed and series, preferring to place any bets on proven CEOs. As larger funds crowd in, they will mostly hold onto their reserves to protect the more promising investments in their own portfolios.
Complicating the picture even further – VC fundraising is now showing signs of slowing dramatically. Q3 funding is down 33% quarter over quarter and a further 55% off it’s pace from last year.
The volatility of the public markets also adds uncertainty to the venture environment. Rising interest rates and fears of recession have led to 50-80%+ valuation drops in post-IPO venture-backed companies over the past year.
Pre-IPO private markets have already seen similar adjustments. This has led earlier venture capital investors to raise benchmarks required to green-light new investments. This has been most dramatic for technology/software companies where growth at all costs was the mantra through 2021 and is no longer the primary criteria driving valuations.
Investors also lose when valuations compress and companies die off. They tend to double down on shorter winners as a result at higher and higher valuations which limits future returns. Only those investors with true conviction that bet on non-obvious founders will reap the rewards of these difficult times.
The Million Dollar Question
Despite the glut of venture funds out there, it will just be more difficult for the average entrepreneur to raise capital given the unique economic environment we find ourselves in . These factors could certainly have a deleterious effect on innovation as less companies get funded overall making it more likely that potentially great ideas never get beyond the pitch deck.
Yet, it’s also true that hard times make the best companies . Necessity requires capital efficiency, and that often leads to better economic outcomes. The founders who are truly strong tend to figure it out one way or another.
We live in a tech first society. That certainly won’t change over the next 12-18 months. As we’ve seen again and again, innovations spurred by hard times fill the landscape of post-recession economies.
The challenges inherent in this economic environment will not ultimately derail tech adoption or blunt innovation. But VC’s normal role in helping tech companies through tough times to spur innovation and recovery may be more muted this time around. At the very least it will look very different from anything we’ve seen in the recent past.