In a recent Wall Street Journal Pro article, Mark Vartabedian writes that venture capital startup activity has slowed to a “trickle.” He says there were more than 54,000 venture-backed U.S. startups at the end of 2023. This was compared to only 12,522 at the end of 2010. He quotes Guru Chahal of Lightspeed Venture Partners, saying, ‘Many ideas got backed at the height of the market that, in retrospect, should probably never have gotten to that stage where there were multiple rounds of funding.’

So, what’s happening here? Where are we in the venture capital cycle? It’s probably a combination of events that creates this venture capital perfect storm.

 

Overfunding in the Venture Capital Cycle 

 

First, it’s not unusual for venture capitalists to over-invest in hot segments of technology.  Renewable energy, digital economy, and artificial intelligence are among the hottest areas attracting capital now. 

There have been many instances in the venture capital cycle when venture capitalists over-invested in specific markets. This leads to concerns about oversaturation and potential bubbles. Here are a few examples:

  •     1980’s:  Disk drive companies
  •     1990’s:  Internet-based “dot-com” companies
  •     2010s:  Cryptocurrency and Blockchain
  •     2010s:  Airbnb and Uber look-alikes, Food delivery (DoorDash, etc.)

In these periods, the influx of VC funding contributed to market saturation, inflated valuations, and too much competition.  Eventually, market corrections occurred, leading to failures, mergers, and a more rational allocation of capital.

It should be noted that some of the thirty or so “top-tier” Venture Capital funds usually enter these markets early, backing the true pioneers. Other funds follow, but not always with excellent results.

 

Poor Liquidity Puts Pressure on Weaker VC Funds

 

How does this create a new stage in the venture capital cycle? The ability of venture capital funds to raise capital is primarily driven by the IPO market. The limited partners who invest in VC funds like to see a lot of IPOs. Why? Because it means the VCs are cashing in on their profits. When they don’t see IPOs, they are reluctant to invest.

In 2023, there were 154 IPOs, down from 181 in 2022 and 1,035 in 2021. This trend has a double-negative impact on VC firms. They can’t exit their deals, so they must keep investing money into companies to keep them alive. The VC funds that don’t have capital in reserve get diluted and eventually find it difficult or impossible to raise additional capital. 

Disaster Phases of the Venture Capital Cycle

 

The above scenario can potentially create a disaster phase in the venture capital cycle. For example, we had cycles like this after Black Monday (October 19, 1987), when the stock market fell 22.6% in one day (still the greatest single-day drop). The IPO market closed immediately and did not open again significantly until late 1991. 

Another similar period occurred after the dot-com bubble burst in 1999/2000. Both of these events forced some venture capital firms to close their doors.

However, there were those that weathered the storm. More robust funds survived because of their reputations and deal-sourcing strength, and these are the same that are more likely to invest in the pioneers who discover breakthrough technologies. 

On the other hand, the weaker funds are more likely to invest in the “me-too” companies that follow, leading to worse outcomes. It’s a matter of access. This difference in access to deals compounds the problem: the rich get richer and the poor get poorer.

I think this pattern mainly accounts for the top-heaviness of the venture capital industry.

 

Newer Venture Capital Funds Have Difficulty Raising Funds

 

A third factor in this repeating venture capital cycle is the gatekeeping. Advising institutions on which venture capital funds to support rarely results in recommending newer funds. They want to see ten years of positive returns before recommending a fund. Again, this just strengthens the existing funds and weakens the lesser ones.  

According to FundComb, only forty venture capital funds in the U.S. are over twenty-five years old. Meaning they have probably raised more than one ten-year fund. Yet another estimate suggests that only 30-40% of venture capital funds raise a second fund. This is a rough estimate, but it illustrates the idea. Note that the forty oldest venture capital funds are the name brand, top-tier funds. These funds continue to raise larger and larger funds and make good returns for their limited partners. Thus, new funds have a much lower survival rate.

 

What Does this Say About Fundraising Strategy for Startups? 

 

Knowing all this and understanding where we are now in the venture capital cycle can help dictate a fundraising strategy. 

Remember, capital is probably still available if you are indeed a pioneer in your field. You should also try to get your funding from a “top-tier” venture capital fund. If you can, it will mean two things:  

  1. Some bright guys probably think you are a true pioneer.
  2. There’s a good chance that your venture capital backers will survive the next downturn in the VC industry and be able to continue supporting you.

 

To get a better idea about managing startups in difficult times, you can read my blog on the topic here. I also give tips on creating winning pitch decks here. You can also always send me your pitch through my contact form