Even the Best Case for VCs is Bad for Startups

Over the last few weeks I’ve spent a lot of time talking to about a dozen startups and quite a few VC investors. And top of mind for everyone is the real state of the economy and how it will affect startups and venture investment.

Startup founders are particularly interested in how a potential economic downturn it will effect their next funding round and whether the market will slow down.

It absolutely will slow down funding. In fact, no matter how the economy does, venture funding at all stages will be impacted.

In fact, it’s important for founders and startups leaders to understand that even the best case scenario for venture capital is a bad scenario for startups for at least the next 6-18 months. And early stage companies need to understand it. 

The reasons go beyond the problems with high valuations and over commitment to startups in the last few years. That is a separate set of problems that venture firms, especially series B and later investors, will have to deal with. And while those companies may be able to grow into their previous valuations, they should have a plan to get to default alive to keep their options open.

That means we will see more down rounds in the future than the currently, which is at around 5% of all rounds.

The reasons for it go beyond a bad economy. In fact, we need to keep in mind that while growth is slowing, we may not enter a recession and in fact, the US Federal Reserve may take action to get us to a soft landing…maybe.

Independent of this we there will be a tightening of investments by VC firms that means more difficult times for startups to fundraise. The reasons are simple.

First, even the best VCs that have capital to deploy and are not attending to an overpriced portfolio are dramatically slowing down their investment pace. There are several reasons why that’s the case.

For one, there is less competition from VCs that have deployed too much capital at high prices in the last few years and that are in trouble. So, they can take their time to look at deals, and they will. They will get back to their previous pace of investigating deals, issuing term sheets, and doing more due diligence.

In addition, they are in a wait and see mode. You see, while multiples have dropped and every VC sees valuations that are more attractive compared to where they were in the last three years, no one is sure that we’ve reached the bottom yet. And there is little downside to waiting.

Beyond that, there will also be pressure from VC limited partners to slow capital down draw downs (LPs giving money they’ve already committed to provide) by VCs to invest. Some of this comes from the lure of higher interest rates that incentivize LPs to invest in higher returns elsewhere. Those rates also mean that LPs are less likely to commit to new funds. But it also makes LPs hesitant to deploy committed capital being called down from existing funds so they can use those funds elsewhere.

Add to this that while there has been a big drop in public market stocks this year, private market portfolios have been slower to devalue. With public stocks down 60% or more limited partner portfolios have shrunk overall. But their private market VC investments haven’t.  In the words one limited partner, “my denominator got a lot smaller, but my venture numerator hasn’t.”  For these limited partners, especially institutions, they suddenly have a much higher allocation of their fund in alternative assets such as venture without any actual increase in investments.

These two factors are leading limited partners to tell their venture general partnerships to slow things down a bit. 

Other factors will weigh in on the slowdown as well. For example, many VCs will reserve more funds for the investments they’ve already made by limiting new investments. 

As a result we are seeing many notable VCs, including Sequoia, and Y Combinator issuing warnings to their portfolio companies to change their expectations and extend their runway.

So how do we get out of this? It doesn’t take much imagination to figure out how things will reverse themselves and startup funding evens out:

1. M&A markets will need to remain relatively strong. A robust M&A market will help, allowing VCs to return capital to their investors. The data from Q1 shows that deal count, total deal value, and valuations were down, but there are currently a lot of buyers in the market, especially PE funds who are sensing a bargain. This will help VCs to lighten up their portfolios, distribute capital to investors, and free up capital to draw down and LPs to invest in funds again.
2. Public market companies will play a role here. If corporate earnings stay strong, or at lease higher than expectations, more money will flow back into the public markets, raising multiples and boosting M&A outcomes.
3. Finally, a soft landing will be achieved if the Fed and others can successfully slow down inflation without having to continually hike interest rates. Slowing interest rate hikes will not only make venture more attractive again, it will free up borrowing for large companies as well which can buoy up growth.

There are a lot of “If’s” to bring things back again. And when they do they won’t go back to the normal of the last ten years, so companies need to change their approach away from growth at all costs and focus on building enduring businesses as Sequoia encourages. Until then, it’s important for startups to recognize that even if the outlook for the economy improves, it will be a tough fundraising environment for some time. 

William Kilmer is a venture capital investor, founder, and innovation strategist. He was formerly the CEO of two companies and was the managing director of Intel Capital Europe. He is the author of the upcoming book, Transformative: Build a Game-Changing Strategy, Retool Your Organization, and Innovate to Win which is available for pre-order in Summer 2022. For more information, visit Williamkilmer.com  

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