The VC Industry at a Crossroads: Navigating Through Uncertain Times
It's no secret that venture capitalists are hurting. The slowdown in VC deal activity that began in late 2022 has persisted into the first quarter of this year. According to an analysis by accounting and advisory firm EisnerAmper, inflation, interest-rate uncertainty, and a low volume of mergers and acquisitions are chilling on the investment landscape.
Venture capital has always experienced cyclical fluctuations, but some industry insiders believe a more profound shift is underway. Scott Stanford, co-founder and partner at ACME Capital, an early-stage VC firm, suggests the changes could be transformative. Stanford shared in an email to Business Insider that it's not crazy to think half the VC firms actively investing in the last decade will sideline and eventually collapse. He predicts the first wave of these closures will occur within the next five years, with the full extent of the damage becoming apparent over the next decade.
The Grim Math Behind VC's Overexpansion
Stanford's assessment is based on a stark comparison of historical data. By 1990, 300 VC firms were managing $17 billion in assets. Fast-forward to today, and there are approximately 3,000 firms overseeing $1.2 trillion. Despite this massive growth in firms and funds, exits have been relatively modest. VC-backed IPOs totalled $12.7 billion in 1990 and only grew to $60.1 billion by 2021. Similar trends apply to VC-backed M&A deals, suggesting that the industry's expansion fails to yield comparable financial returns.
The venture industry, Stanford argues, got ahead of itself. "Euphoric momentum investors, not technologists, drove the creation of funds and the deployment of capital, blind to the nuances and challenges of timing innovation cycles," Stanford and ACME cofounder Hany Nada wrote to investors. This disconnect between the proliferation of VC firms and their actual value creation is now leading to an overcrowded, overcapitalised, and overvalued market.
New Challenges for VC Backers
Several factors are likely to thin the herd of VC firms. Thanks to higher interest rates, limited partners, the investors who fund venture firms, now have more attractive alternatives. Safe investments like Treasury bonds offer decent returns, making them a viable option over riskier VC investments.
Moreover, the tech sector no longer commands the same irrational M&A premiums or IPO exuberance it once did. In the past, a startup could secure a billion-dollar valuation simply by positioning itself as a tech company. That era is over, with today's environment demanding more substantial proof of innovation and potential for growth.
While artificial intelligence is a hot topic, it is not necessarily the next magic bullet. Leaders like OpenAI share their technology openly, allowing anyone to create decent products. This democratisation of AI technology means it's less likely to produce the next generation of unicorns that VCs hope for.
The Future of VC: Back to High-Risk, High-Reward Roots
Only VCs with deep expertise, strong networks, or significant funds will thrive in this challenging environment. "A VC without capital is like a tennis player without a racquet," Stanford said. "They can give interviews and make headlines but aren't invited on the court."
Stanford believes these challenges could herald a return to an older style of VC investing that embraces high-risk, high-reward opportunities. In recent years, many startups have raised millions of dollars to create slightly improved versions of existing products. However, with industry incumbents capable of making such incremental improvements, VCs must now back truly innovative companies inventing new technologies and solutions.
This shift will require a renewed willingness to take risks. Companies that succeed will offer significant returns, while those that fail will do so completely. This return to a high-risk, high-reward model could potentially lead to a renaissance in technology, where "systems work for us versus us working for them," as Stanford and Nada envision.
In conclusion, the venture capital industry stands at a critical juncture. The current slowdown is more than just a cyclicaldownturn; it's a wake-up call for VCs to refocus on genuine innovation and sustainable value creation. The firms adapting to this new reality will emerge stronger, potentially leading the next wave of technological breakthroughs.