Slump puts startups' fates in hands of all-powerful VC insiders

About a year into the downturn, the VC-backed universe looks relatively unscathed.

Sure, there were some large-scale layoffs at companies that overstretched during the bull cycle as well as spectacular failures in the highly speculative crypto industry, but judgment day has yet to come for most startups.

That day is still coming however, and in many cases, companies' existing investors will play the role of God in deciding their fate.

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In recent weeks, VCs have been getting louder and more candid about the impending reckoning.

You already know how this chapter began. Many startups raised capital at insanely high valuations when money flowed freely during the pandemic years. Then, the US Federal Reserve decided to raise interest rates to combat inflation and tech stocks tanked. As a result, startups' implied values plummeted. VCs responded by advising their portfolio companies to make their cash last as long as possible.

Startups obliged—some more, some less. But for most early-to-mid-stage companies, all the cost-cutting is probably insufficient to get them to profitability. They'll need another infusion of capital.

"Everybody on earth is going to need money between Q4 of this year and the first half of next year," said Tom Loverro, a general partner at IVP. This week, Loverro posted a Twitter thread predicting "a mass extinction" of VC-backed companies.

He told me that the best businesses should be fine. The "good companies" will succeed at raising capital from outside investors, albeit possibly at a down round or in a lightly structured financing.

But what about the rest of the startup world?

Well, those companies will likely need help from insiders. During the boom years, it was commonplace for existing investors to aid their portfolio companies through financially challenging times. Since VCs wanted to guard their founder-friendly reputations and there was a reasonable likelihood that the next round would eventually materialize, they were often ready to provide bridge financings to get their investments to their next milestone, whether product-market fit or securing a large customer.

But now that the market is favoring "path to profitability" more than "growth at all costs," founders shouldn't expect their backers to come to their rescue.

When asked what percentage of portfolio companies he would support, a general partner of a sizable firm founded more than 20 years ago told me, "About half." He added, "Maybe other investors on the cap table will support these companies, but we won't."

More than twice as much capital was requested by startups than was supplied in Q4 2022, PitchBook researchers estimate. The phenomenon of demand outpacing supply holds true for all stages of the venture market, but is most acute in the late stage.

While other VCs I spoke to didn't share the proportion of current investments they plan to abandon, it was clear that they will be much more disciplined about providing bridge financing than they have been in the past.

Their concern is that, unless they are certain that the bridge will lead to somewhere concrete—such as a venture debt deal, profitability or an exit—the funding will turn into a pier, and piers just drop into the water.

Chris Shoff, an attorney with Goodwin, said that he is starting to hear VCs telling their portfolio companies that they don't plan to invest more capital even if it comes to a pay-to-play situation, a deal in which non-participating investors lose their preferred shares.

Venture capitalists need to preserve their capital too. Top-notch firms used to snap their fingers and a fund would magically appear, said one LP. But in the current environment, it's taking them over a year to close a new vehicle.

What's more, unlike startups, VCs have the luxury of time on their side and can hold off for better opportunities. Rather than using their precious dry powder for supporting weaker startups, they might save it for hot new areas like generative AI or for picking up stronger companies at lower valuations 12 months from now. 

In the current environment, when capital is expensive and the state of the economy is uncertain, a quote attributed to Oliver Cromwell, the 17th-century British politician and general, comes to mind: ''Put your trust in God, my boys, but mind to keep your powder dry.''

It's best not to rely on others, even the most well-heeled VCs, when survival's on the line.

Related more: When Dry Powder Stays Dry

Featured image by Jenna O'Malley/PitchBook News

This article originally appeared on PitchBook News