Opening the Floodgates: The $290 Billion Venture Capital Reserve
The VC industry has record levels of dry powder after a summer slowdown in deal pace. Are we heading for a long drought or will the floodgates open once again? Our forecast suggests record levels of funding will continue for several years to come. These findings were also published by Kate Clark in The Information.
“Gravity is a force so basic we often don’t even notice it.” ― Sakyong Mipham
Founders today are wrestling with two different outlooks on the VC market. A global recession, a stock market correction, and a summer slowdown in VC funding paints a public picture of doom and gloom. At the same time the VC industry has raised $573 Billion since 2016 (and a record setting $261 Billion in the last 6 quarters alone) signaling optimism that there are plenty of funds to put to work. The job of running a startup is hard enough, and reconciling these two different narratives makes long term planning even more challenging. Should you cut your burn rate and prepare for the worst? Or should you accelerate and plan to raise another round next year? No founder can predict the future, but we are all at our best when we can build optimistic and realistic plans for the road that lies ahead.
Two years ago we began tracking “dry powder” in the VC industry, a measurement of how much capital is sitting in VC funds to be invested in startups. Dry powder is the total amount of capital that VCs have to invest in existing or new companies, and is reported quarterly by the NVCA and Pitchbook. As of the end of June 2022, this number was recorded at an all time high of $290 Billion, almost twice the amount seen on average pre-COVID.
The amount of dry powder helps us determine the quarterly rate at which VC funds invest their capital — a number we refer to as the “burn rate” of the VC industry. When a VC firm raises money, it generally commits its capital to investments over a 3 year investment period (this number was shorter during the COVID boom, but on average 3 years is a good rule of thumb). Though there is some variance across funds, in aggregate the industry invests capital at a relatively predictable pace, generally investing 8–9% of dry powder every quarter. Our market is a long term competition for returns, and every firm is in the race to finish in the top quartile and cannot afford to sit on the sidelines.
Using long term averages for the rate at which VCs invest allows us to use dry powder as a strong leading indicator of how many VC dollars will be invested in the coming years. Our dry powder model suggests that the VC industry will have only a modest slowdown this year in comparison to last year, and will continue to see record levels of investment in 2023 and 2024. There are many factors that can create variance in any prediction, but a record level of snowpack in the mountains makes it easier to forecast water flowing downstream. At the end of the day, it is hard to bet against gravity.
Many founders may assume that our analysis foreshadows a return to the highest of highs in 2021 for startups. As the VC industry increases its pace in the coming quarters, We believe there may be some substantial differences in how the capital will be allocated:
- The public market correction has made it more difficult for later stage investors to continue to invest at record high valuation multiples. A lot of companies will continue to grow at exponential rates, but we expect more flat and insider supported rounds for later stage companies that raised last year as the market tries to find a “new normal” level for private valuations.
- The return of “growth plus efficiency” valuation metrics vs. “growth at all cost” operating plans will lead to a right sizing in funding needs for most startups. Expect fewer mega rounds at earlier stages as companies find more optimal funding levels to address their near term growth needs.
- We see the combination of normalized valuations and round sizes overall leading to more capital available for each and every company. This is called the “trickle down” effect — less capital is absorbed in the later stages of the market, increasing the amount of capital to be invested across every stage.
- As funds trickle down and shift from later to earlier stages, companies with great technical progress, strong founding teams, and market momentum will continue to be rewarded. Expect the early stage market to be one of the most vibrant areas of investment in the coming quarters.
The VC industry has evolved over more than 50 years, and throughout its short history has found a way to evolve and support the next generation of great creators and innovators. This time will be no different — there are more than 15,000 VC backed companies today and there will soon be an incredible funding environment to grow our industry’s most promising companies. Are you a founder that is planning on raising next year? It’s time to get ready. When the VCs open the floodgates, they will be eager to invest.
For more information on the dry powder forecast, e-mail me at firstname.lastname@example.org or DM @jonsakoda on Twitter.