The Collapse of the VC Ecosystem & What It Will Look Like Post Recovery
The venture capital ecosystem is in the midst of an historic collapse. I say ecosystem as opposed to industry because it is not just the VC funds themselves that are imploding, instead the collapse includes entrepreneurs and startups that were funded by VCs, angel investors, service providers like lawyers, bankers and accountants as well as limited partner investors in VC funds. It doesn’t get talked about much because the structure of funds is such that their fall is in slow motion and because all the major players are private companies. There are no press releases when a fund goes out of business or when partners leave.
Like in most things, all VC funds are not affected equally. There are three types of venture investing (early stage, “growth” stage and later stage. Early stage means the first real investors in a startup when the team could be as small as 5-10 people. Growth stage investors are usually the Series B or C investors who come in when the product is in the market but there is little or no revenue and the team is probably in the 20-something range with the goal to ramp it up to 40-50 employees with the new money, build out a sales team, etc. Later stage investors typically put money into a company once it has crossed the chasm with at least one product and achieved a $10 million+ revenue run rate.
So in the current collapse, the later stage investors will fare the best, or should I say least worst. Their portfolio firms will be able to cut back on headcount and other spending and additional capital from investors will allow the companies to survive for the 2-5 years it will take the market to begin to recover. Later stage funds will end up owning more of their portfolio companies via down rounds and ultimately should see ok returns.
The early stage investors are going to take a huge hit since many of their portfolio companies will be capital starved and will be forced out of business or into fire sales. But some will be saved. Many of these early stage companies still have the founder as CEO and they will retrench and “go back to their bootstrap roots.” It’s painful, but they will cut headcount back to 5-10 employees (if they haven’t already) and they will survive off existing capital ultimately generating a decent return for investors (compared to the benchmark).
Which leaves us with the “growth” stage investors, a.k.a. “Series B” funds. These VCs will see an almost total wipeout of their portfolios. The problem is that the portfolio companies of these funds are burning too much cash and they are not yet a real business with any revenue to speak of, certainly not of any scale approaching breakeven. The problem is compounded by the fact that many of the founding CEOs have been replaced with “professional” CEOs who do not have the DNA or interest in retrenching to 5-10 people and live to fight another day. All of the Series B investments made in the past couple of years were based on a belief that the market for the companies products would mature over the coming couple of years and that’s just not going to happen.
In retrospect, I’m not sure that “Series B” investing is a real business anyway. To me it’s a sort of no man’s land between the two trenches of early stage investing and later stage just before exits. It reminds me of how real estate mortgages were securitized and the guys in the middle were thinking they created value (when in reality they just eliminated responsibility). Early stage investing is complicated, hard work. You need to identify “winning” entrepreneurs and big potential markets that don’t exist yet. The later stage guys needs to have relationships and expertise around selling companies. But the folks in the middle don’t really do anything other than fire founding CEOs and add capital. The “Series B” guys will argue that they have expertise in building sales teams but in reality they often push this too soon and end up creating really inefficient companies that are trying to sell a product/service before it’s mature enough.
So the “Series B” investors are going to be pretty much wiped out in this current collapse and I actually don’t see them coming back afterward in a way that is recognizable today. I think the first funds to come back after the collapse are going to be the early stage funds. These were the first to stop investing last summer and like the economy generally it’s a FIFO system (the first group into recession is likely to be the first to come out). What will happen is that there is going to be a build up of really talented entrepreneurs running underfunded, but great companies and this “over supply” will attract new “Series A” investors.
The later stage guys may see a pickup about the same time as the Series A guys but I suspect it will take longer (like the recovery after the 2000 crash). The turning point will come when large corporations that buy these later stage companies have cleaned up their own balance sheets and are again looking for growth opportunities.
So what to do? Well, it depends what part of the VC ecosystem you are in. If you’re an entrepreneur you should consider a really early stage company (or start one yourself) or you should consider joining a later stage $10-20MM revenue business that has potential, but at all cost avoid the $2MM revenue Series B startup! If you’re a VC yourself, I’d make sure I wasn’t stuck in no man’s land and I suppose that advice goes for all the other service providers.
UPDATE 1: A few people have asked me if I have any data on an impending collapse of the VC ecosystem or if this is all anecdotal. As I mentioned earlier, these are all private companies so data is hard to come by. What I can tell you is that total private equity assets under management was reported as $2.5 trillion as late as last month. That figure includes $1 trillion of un-invested funds (a.k.a. “dry powder”) and $1.5 trillion of unrealized returns. As everyone knows, what is being reported as dry powder isn’t real as many of those LP commitments would not survive a capital call (and thus capital calls aren’t being made). Also, the $1.5 trillion of unrealized returns is by and large the valuation based on the price paid or the most recent round. And since all assets are down 50% globally in the past year, and there is no reason to believe that VC is any different, that implies that the industry just lost about $750 billion but accounting rules do not require them to declare that yet. That seems like a collapse to me.