When economies lurch towards recession, VCs traditionally play a crucial role in sustaining tech companies that help spur innovation and market recovery. The forces shaping this particular economy, though, are unique and venture capital’s historical role is less certain as a result.
VC’s Traditional Role
Economic downturns often lead to absences in the marketplace providing opportunities for tech-forward entrepreneurs. We saw it most recently at the onset of COVID-19 when organizations were forced to rethink the entirety of 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.
Should we expect to see a similar burst of entrepreneurship and funding as we move to the other side of this economic slowdown? The short answer is yes, but getting there will be complicated.
What’s Different This Time?
The tech industry has been particularly impacted by the most recent market crash. The need to do more with less as a result of sector-wide belt tightening is usually a good thing for tech. But there are problems just below the surface in the venture markets that may hamstring tech companies this time around.
There's actually record numbers of VC funds getting raised right now. In July it was reported that VC funds in the US had already closed $137.5 billion, just shy of 2021's full-year total of $142.1 billion
However, unlike 2021 — where funds across the board were raising money — most of the capital in 2022 is being raised by mega-firms like Lightspeed, Andreessen Horowitz and Insight Partners. This has a tremendous impact on how and where venture money is deployed since the mega-firms behave and invest very differently from the rest, choosing 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, leading 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 sympathy for what the VCs paid before them.
Normally an abundance of capital would indicate 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, preferring instead to place their bets on fewer proven CEOs with stronger backgrounds. 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.
To complicate the picture even further VC investment is now showing signs of slowing dramatically. Q3 funding is down 33% quarter over quarter and a further 55% off its 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; and, although more slowly, this has already led earlier venture capital investors to raise benchmarks required to greenlight 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.
While this may present more favorable conditions for new Seed and Series A investments, the glut of venture money being held by fewer and fewer firms who tend to make larger and larger bets on a finite number of tech companies counteracts that potentially positive secondary effect.
Not only is the greater economy impacted when valuations compress and companies die off. Investors also lose. They tend to double down on shorter winners at higher and higher valuations such that future returns are limited. 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 the best companies are built in hard times. Necessity is necessarily capital efficient and that can lead to really good economic outcomes. The founders that are truly strong tend to figure it out one way or another.
We also 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.
