The Coming Washout
According to PitchBook, venture funds worldwide recorded their best performance among all private capital strategies in 2021, attaining an IRR of nearly 20 percent.
(NB: to learn more about IRR—especially for startups—you can check out my earlier thoughts on the subject here.)
By mid-year 2022, though, these rates of return had plummeted to just 10%.
One cause of this decline is the increasing time gap over the past decade from Series A investment to IPO. This lengthening of time to acquisition or public offering has depressed IRRs.
Meanwhile, the mix of IPOs to M&A exits has also changed. In the 1990s, the IPO to M&A ratio was 1:1. In the 2000s the ratio slipped to 1:7, and that number has further declined in recent years.
While this is a reasonable shift as end-markets mature, multiples generated by M&A exits have dropped from 7x to 2.7x, compressing returns.
Adding to the pressure, the backlog of venture-backed companies waiting for exits—especially as the IPO pipeline is now all-but closed—increased steadily in the 2000s. A fraction of the companies funded annually exit in the ideal five- to seven-year timeframe, and many are taking more than a decade to achieve that goal. Even if we doubled or tripled the current pace of exits, we’d need several years to work through the crowded field of companies waiting to do so.
Here's my bold prediction for 2023: By the end of the year, 30 to 40 percent of VCs will close up shop. Approximately 400 to 500 VCs will not raise another fund, effectively leaving fewer VCs to fund startups and new ventures.
I say this for two main reasons:
First, there’s over-funding. In 2021 VCs funded over $276 billion, a record amount which more-than doubled the 2020 figure.
Second, but maybe more importantly, many VCs overpaid for startup investments in their eagerness to remain competitive. In other words, valuations went “cray-cray.”
But that’s not all:
Many well-funded startups will run out of money in 2023-2024 and go bankrupt.
The VCs who helped capitalize startups with high valuations and large rounds may be severely limited or out of funds to help raise another needed round.
A bunch of VCs invested directly in massive losers like cryptocurrencies (Bitcoin, Ethereum and Solana), crypto-exchanges (FTX, Coinbase, Tradestation, etc.) or FTX exchange tokens like Serum, Maps.me and Oxygen.
Conditions like acuiqhire exits, small acquisitions, and the lack of IPO opportunities will further dampen IRRs.
Many of these companies will not be able to adapt to the new break-even or cash-flow positive realities.
These companies must discover ways to thrive in a downturn, something their leaders may struggle to achieve.
Ultimately, large LPs will come to regard all but the top VCs as a less-productive asset class, and won’t capitalize new VC funds as they did in 2016-2020.
What happens next?
On the exit front: There will be many asset deals, and “cheap companies” face acquisition by smart purchasers, usually well-heeled public companies with expansive cash positions. Startup survivors will possess capital because they’ve already raised funds. Further funding will depend largely on EBITDA visibility.
On the funding front:
For Angels: Some early stage companies simply won’t make it. Other, hard-pressed, startups will need a “down round” funding, or another seed/SAFE round to survive. This will be a challenging time for angels to orchestrate recaps and make executive management changes (to shed executives who can’t cut it in the new paradigm), and implement survivor scenarios.
For VC funds: Excess dry powder will all but go away. There will be recaps and difficult funding rounds for companies that run out of cash. (Expect the return of 2+ liquidity preferences.) There will be a 1- to 2-year “break” in cash infusions at least until we find the true bottom of the downturn. Investments will take longer. Due diligence will increase in intensity and scrutiny, and VC deal thinking will focus on “the path to profitability.” Post-money valuations will be lower in seed-Series A-and-beyond rounds than even 2021 levels, and the capital raised in each round will decrease in most deals. Low performing partners may be terminated or transitioned out of the partnership.
For Corporations: There will be industry- and technology-specific investment opportunities for smart companies via off-the-balance sheet funding or corporate VC funds. These “strategic” investment options will be attractive to many startups, but the length of time for a funding round, increasingly demanding due diligence, and absence of support will be negatives to consider.
Looking forward, all losers in the startup funding ecosystem will eventually reset. The lion's share of investors will return to the next bull market.