When VCs Run Out of Funds
When venture capitalists (VCs) run out of funds, it has significant implications for their portfolio companies, new investments, and the broader ecosystem.
Implications for Startups
This is what happens when your startup is part of a VC portfolio that has exhausted its funds.
Fundraising Challenges: VCs face fundraising challenges when needing to raise new funds, often relying on strong performance from previous investments, which can be difficult if returns are delayed or weak. Failure to secure a new fund may damage the firm’s reputation, complicating efforts to attract Limited Partners or secure competitive deals
Portfolio Management: VCs face challenges in portfolio management, often limiting follow-on investments and leaving startups reliant on new investors or at risk of running out of funds. They tend to focus resources on their top-performing companies, sometimes neglecting others in the portfolio. Additionally, VCs may pressure startups toward liquidity events, such as acquisitions or IPOs, even if the timing is not ideal, to free up capital or demonstrate returns.
Impact on Startups: Startups can face significant challenges when their primary VC's fund is depleted, making it harder for startups in their portfolio to secure additional capital. This may force startups into a down round, accepting funding at reduced valuations, seeking bridge financing under unfavorable terms, or undergoing recapitalizations where investors have their ownership crammed down. To mitigate these risks, startups often need to diversify their investor base to reduce dependence on a single VC.
VCs prefer to back high performers, so if your VC isn’t continuing to support you, it’s likely due to performance. Even if you think you're doing well, your metrics and prospects might not compare favorably to others in their portfolio—but if you truly are performing, other VCs should be willing to fund you.
Broader Ecosystem Effects: When multiple VCs deplete their funds simultaneously, it can create funding gaps, particularly in specific sectors or stages like early-stage startups. This reduced capital availability shifts market dynamics, leading to lower valuations, stricter deal terms, and a heightened emphasis on profitability overgrowth.
The data shows that VC funding has faced significant declines during major crises: the Dot-Com Bust (2000-2002) saw investments drop from $105 billion to $19.6 billion, the Global Financial Crisis (2008-2009) caused a decline from $30 billion to $20 billion, and the COVID-19 pandemic led to a 22% drop in early-stage deals in Q2 2020. More recently, the 2022 tech valuation reset reduced VC funding by over 35% from 2021's record highs due to rising interest rates and economic uncertainty.
What’s happening now—post-Zero Interest Rate (ZIR) era—is that the "tourist" VCs are exiting, leaving behind the serious, committed investors. While the landscape may still appear challenging, it is fundamentally healthier and more stable beneath the surface.
We know that established VCs with strong track records typically navigate challenges better than smaller firms, reflecting the pressures of a complex investment landscape.
Strategies for Startups When VCs Run Out of Funds
When a VC firm runs out of funds or is unable to participate in future rounds, startups must adapt to ensure survival and growth. Here are some strategies that begin with internal optimizations, progress to external approaches, and conclude with contingency planning:
Optimize for Cash Flow and Runway: Streamline expenses, prioritize high-margin offerings, and accelerate revenue growth through pricing adjustments or new streams.
Expand the Investor Pool: Seek funding from alternative sources like other VCs, angel investors, corporate venture funds, or crowdfunding platforms. Engage strategic investors who align with the startup's goals.
Strengthen the Board: Add members with strategic vision, funding connections, industry and M&A expertise, and a focus on meaningful contributions to enhance decision-making and drive growth. Remove unproductive observers.
Syndicate and Pay-to-Play! Pursue a syndicate of multiple VC funds, starting with the Series A round. Also, consider a pay-to-play provision starting with Series A.
Think Early Strategic Funding! Start early on building relationships with multiple key customer industry participants who have investment arms with the goal of getting them both as customers and investors. (At Black Duck we did it, by design, with Red Hat, Intel and SAP in Series A and B.)
Explore Strategic Alternatives: Form partnerships, pursue M&A opportunities, or monetize assets through licensing or spin-offs to secure resources and liquidity.
Pursue Non-Dilutive Financing: Explore SBIRs, state funding, grants, subsidies, revenue-based financing, or venture debt (highly unlikely) to secure capital without giving up equity.
Strengthen Operations and Metrics: Demonstrate resilience through key metrics, highlight traction in critical areas, and ensure financials and plans are investor-ready.
Adjust Funding Strategy: Accept a flat or down round if needed, and structure tiered investments tied to milestones to attract cautious investors.
Enhance Stakeholder Relationships: Leverage existing investors and advisors for introductions, maintain transparency, and build credibility through strong relationships.
Expand Your Options Pool: Supporting down rounds (even punitive down rounds) as long as the newly expanded option pool is dedicated to (and sufficiently large to adequately incentivize) those executives and key employees then providing services to the company.
Communicate a Compelling Narrative: Highlight the long-term vision, address risks transparently, and use data to validate market potential and positioning.
Leverage Community and Ecosystem Support: Tap into accelerators, alumni networks, and startup competitions for funding, mentorship, and increased visibility.
Prepare for Worst-Case Scenarios: Consider making a pivot to a more viable market, product, or customer segment to ensure sustainability. Consider a pursuing a moderate exit, if necessary, rather than going for an extraordinary one.
These measures, combined with strategic thinking and flexibility, will ensure sustainability and growth.
Conclusion
The challenges faced by startups when their VC runs out of funds underscore the importance of proactive financial and operational strategies. By diversifying funding sources, optimizing cash flow, and strengthening stakeholder relationships, startups can navigate these turbulent periods and position themselves for sustained growth. Ultimately, resilience and adaptability in the face of funding uncertainties can transform potential setbacks into opportunities for long-term success.