Summary.    The startup world is currently debating when venture capital investing will return to its pre-2022 heights. The bullish case is that VCs have lots of “dry powder” — capital that’s already been committed. That money will get invested one way or another, the thinking...

Venture funding for startups suffered a 50% year-over-year drop in the 3rd quarter of 2022. While most participants in the startup ecosystem were expecting a downturn, this dramatic pullback in deployment is sure to send chills down the spine of many founders and funders.  

Some, like venture capitalist Jon Sakoda, believe the funding downturn is transitory and argue that the $290 billion of committed capital to venture capital firms is “dry powder” that will re-energize the startup market in 2023. As a VC myself, I sincerely hope he and others in the optimistic camp are correct. However, investors and entrepreneurs need to prepare for what could be a massive level of attrition that could occur if the funds are deployed more slowly.  

Here are a few reasons why I’m encouraging founders to focus on their existing runway and not to pin their hope on dry powder. 

VC funds will focus on their key holdings.

$290 billion is, objectively, a lot of money. But where it’s deployed matters quite a bit. My hunch is that VCs will reserve most of it for the most promising companies already in their portfolio.  

Tough times put investors into triage mode. Mature startups with proven business models and the potential to reach the public markets within a few years will be the safest place to park any new venture capital that comes into the ecosystem. The pressure to protect portfolio startups seen as potential fund returners will be profound. 

Beyond that fortunate group, the funding situation will be less secure. The market for pre-seed and seed rounds should remain relatively active, since those companies are many years away from even thinking about going public. But even in the seed market the bar could get higher: I wouldn’t be surprised to see valuations drop and for VCs to have rising expectations about the level of traction they expect to see before funding. 

Series A and B startups may be the hardest hit. Many teams that have made solid progress but still present unanswered questions about their product-market fit, go-to-market strategy, or total addressable market size may struggle to raise their next round on any terms. As with the growth stage companies, VCs may focus attention on the top 10–20% of their portfolio. Startups that maximized their valuation over the last year or two and whose progress on key metrics hasn’t caught up to that valuation may find it hard to find many eager audiences. 

Why doesn’t the VC market adjust to the current climate by just lowering startup valuations? Unless the startup has made substantial financial progress or has developed easy-to-value technical assets, “down rounds” aren’t worth the trouble for most VCs. Recapitalizing a startup requires the new investor to balance the legal rights of the existing cap table, resetting the expectations of employees, and their own needs — it’s almost always easier to fund a new startup. 

Investors have to sort out a cash flow logjam.

To understand why VC funding might get harder to raise despite the “dry powder,” it’s important to consider where the money comes from. In his writings, Sakoda compares the dry powder to a snowpack in the mountains that will eventually melt and trickle down to startups of all stages. While this image is a helpful metaphor, it could lead one to believe that the dollars are just sitting around, waiting to be wired to VCs. 

The reality is more nuanced. VCs get their funds from pension funds, sovereign wealth funds, endowments, and family offices, among other sources. These limited partners, or LPs, manage incredibly complex portfolios, and this period of upheaval creates a series of nested puzzles they need to solve to fund their commitments to VCs. 

In a practical sense, LP cash flow comes from the liquidity received from realizing prior investments — meaning that the money they can actually deliver to VCs depends on their other investments. Unfortunately, liquidity has been much less common over the last year, which may impact their balance sheets. Unrealized gains from markups are nice, but cash returns are what ultimately decides where future dollars are allocated. Add to that the steep drop in public market valuations, which reduces the capital they can expect to receive as lockup periods for recent exits expire. It also forces them to revalue the models of private holdings, further reducing what they expect from future proceeds. All told, these decreases combine to create a “denominator effect” for many LPs whose venture holdings are too large relative to other asset classes. Say a fund aims to have 5% of its assets in venture capital. If the value of all its non-VC assets drop precipitously, it can find itself with more money committed to VC than it is comfortable with.  

Then there’s the fact that rising interest rates create other, lower-risk opportunities for LPs’ capital. Funds might rethink their VC commitments not only because their assets are less valuable or less liquid, but also because other investments are looking more promising. 

The $290 billion could evaporate.

What happens if an LP suddenly is uncomfortable with their prior commitments to VC? They can either ask out of or “default” on their commitments. Or, they can simply tell VCs they’d prefer the money be invested more slowly. 

During the 2001 downturn, many VC firms “returned” their capital commitments to their LPs. As Benchmark’s Bill Gurley recently noted, investors presented this as a noble act of responsibility: they were doing right by their LPs. To a more critical eye, it was an expedient that allowed VCs to start a new fund without the overhang of investments made in a poor vintage. The LPs got their money back and the VCs avoided having to explain a bad track record. Perhaps this practice will make a comeback, freeing funds with high-performing histories to start new vehicles while reducing the overall burden on the LPs.  

LPs can exercise soft power.

The scenario above is generally considered unlikely because LPs rarely default on commitments. The implication is that if LPs don’t default then the return of startup funding is a fait accompli. This assessment of the legal structure of partnerships is accurate; reneging on obligations to VCs would damage the LPs’ brands and lead to substantial forfeitures. However, LPs can signal to their VCs that a slower investment preference would be preferable. 

While VCs might have a contractual or moral right to deploy at the agreed-upon pace, disregarding their LPs may lead to a lack of participation in future funds. Most GPs will take feedback from their key clients. Whether VCs decide to deploy that $290 billion over two years or five makes a significant difference. 

One of my firm’s LPs, Patrick Cairns of Union Grove Venture Partners, explains it like this: “Companies need to raise capital to survive but fund managers don’t need to deploy capital to survive. A 10-year fund might have a 3–5 year investment period in the limited partner agreement. In fact, after a few years of accelerated deployment, LPs might prefer funds demonstrate a bit of patience through the early part of this cycle.” 

I hope my assessment of the situation is wrong. Nothing would make me happier than to see a quick rebound of the stock market and a revitalization of the startup bull run that stretched from 2011–2022. Unfortunately, we must also be ready to navigate a prolonged stretch of uncertainty. 

In the meantime, startups should reconsider their funding plans and whether they can reach profitability sooner than they might have otherwise. Nadia Boujarwah, the Co-founder/CEO of plus size clothing upstart Dia & Co. recently reorganized her company to get to profitability. “Getting to the point where we controlled our own destiny and were no longer dependent on outside investors was invigorating,” she says. “We had to make difficult decisions, but they have given us the freedom to grow. I would encourage more founders to think hard about finding ways to control their own destiny.”  

In any case, the advice I’ve been giving to the founders in my portfolio is simple: hope for dry powder, but until it materializes, try harder to make the most with the resources in your control.