In a recent Marketplace.org article titled, “Startups are hoping for a turnaround in funding“, they discussed whether the current funding climate will have a turnaround. I believe they have it about right in stating that prospects for a turnaround are mixed, but they missed a few factors relating to how funding flows.
The Current Funding Climate is Due to Complex Factors
According to the article, startups in “hot” areas like Artificial Intelligence are having an easy time raising capital, while for other startups, funding is more difficult.
However, I think the article misstates how funds flow into venture capital funds.
The current funding climate is due to more complex factors than which areas are “hot”. The relationship between funds invested in portfolio companies and funds received from IPOs is complicated.
Venture capitalists can easily raise additional capital when the IPO markets are robust and they have some exits to show their limited partners. So, if their current fund becomes fully invested and they have been reasonably successful, they will probably be able to raise additional capital. This allows them to invest in portfolio companies.
But what if a venture capitalist is sitting on a portfolio that has not provided any profitable exits and the IPO market is slow? The fund is likely to receive a response from limited partners like, “Not now. Come back when you’ve had some exits.”
Existing Investments Must Be Protected First
Venture capitalists are forced to reinvest in their existing portfolio during periods of poor liquidity and slow IPO activity, just to keep their companies alive. They have to keep putting capital into their portfolio companies. But they may not be able to raise additional capital from their limited partners.
During these periods, the larger, well-funded venture capital firms are usually able to continue supporting their portfolio companies until the IPO market reopens. However, the smaller venture capital funds frequently lack the capital to protect their existing investments. This results in them being heavily diluted and unable to raise additional capital. This is causing the current funding climate, but it is part of a familiar cycle.
What We’re Seeing is Part of a Cycle
Do venture capital funds go out of business? Well, not really, in a sense. Most venture capital funds are set up for ten or more years, with some options for limited partners to extend their lifetime if necessary. So, if a venture capital fund runs out of capital, it doesn’t really go out of business. It continues to monitor its existing investments and returns capital to limited partners if some become profitable.
So, there’s a definite cycle during periods of slow IPO activity where the rich get richer. The large venture capital funds protect their existing investments until they get some IPOs and raise additional capital. Yet the smaller venture capital funds get diluted and are unable to raise additional capital or make new investments. This is what we’re seeing in the current funding climate.
This cycle occurred after Black Monday, October 19, 1987. It occurred again after the dot-com bubble burst in 2000. And it occurred again after the market turndown in 2008.
How This Relates to the Current Funding Climate and When Will We See Change?
Therefore, the proceeds from today’s IPOs will not be reinvested in new portfolio companies. Proceeds from today’s IPOs will probably be distributed to the limited partners. Today’s IPOs will enable the venture capital fund to raise additional capital from its limited partners for their next fund. This may then provide capital for today’s new startups. The current funding climate will not last forever, in other words.
It takes most venture capital funds a year or two to raise a new fund. So, given today’s relatively low IPO activity, it will probably be a few years before significant funds flow into the venture capital industry. This doesn’t mean there is no venture capital for startups. It just means that funds will be limited in the near future. Also, venture capitalists will be more selective than ever.
If you want to know more about how you can increase your startup’s chances for funding in the current funding climate, my blog is a great resource. I suggest starting with my article on creating an effective competitive strategy.
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