Road Less Ventured
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Road Less Ventured

Why an economic downturn may not affect the VC landscape uniformly

It’s the start of the new year which means many people are prognosticating about what 2019 will bring. One thing I noticed this year is that many expect something between a correction and full on recession. This leads to the inevitable “raising VC funding will be harder” prediction for startups. While there is definitely some truth to that, I think the fundraising environment for startups will be much more nuanced given other dynamics currently unfolding.

Admittedly I have no idea whether a recession is coming or when. This post is not about predicting an economic downturn, merely what that economic downturn would mean for startups raising capital IF it does happen in 2019. I tackled this same issue back in early 2016 when winter was supposedly coming to startupland and that turned out not to be the case.

Before I dive into the nuances about what makes 2019 different than past corrections, I want to dive into what we have historically have seen happen during a downturn. The first thing to understand is that during a recession a few things happen in the public markets that have an impact on venture funds. The first is that multiples compress. We are already seeing some evidence of that taking place now.

Source: Tomasz Tunguz:

When this happens, VCs see smaller potential exits and thus need lower valuations to get the same return. This factor leads to an increased number of flat or down rounds during a downturn.

Second, LPs become over allocated to venture as an asset class. Many institutions have target allocations to venture. During a recession, the value of an LPs entire portfolio drops significantly but because venture funds are illiquid and the amount of capital it has committed to venture as an asset class remains constant. This means that as a percentage, venture often times goes above those thresholds and LPs stop investing in new funds making it harder for VCs to raise their next fund.

VCs know this, so they become more conservative deploying the capital they do have. This in turn makes it harder for startups (in aggregate) to raise their next round of financing. Companies with good financial or customer metrics still get funded, but many others that otherwise could have raised money in good times may not be able to.

So what is different about today that might counter-act some of these historical effects of an economic downturn?

First, there is still tons of capital that needs to be deployed over the next couple of years. 2017 was a banner year for VC fundraising and although I don’t have the 2018 data yet, all indications are this could be another record year. VC funds have raised almost as much as they did all last year in the first three quarters.

Source: Pitchbook:

VC’s aren’t paid to sit on capital, so investors will continue to deploy capital over the next few years regardless of the economic climate. The question will become if they continue to fund net new investments or if they begin saving more of that capital to help their portfolio companies weather an anticipated tougher fundraising climate.

Second, there are a number of huge IPOs on the docket for 2019. Assuming most of these do happen (admittedly it seems like we have been saying this for the last couple years so this is still a big unknown), it would return a significant amount of capital back to LPs and some of this capital will get reinvested into venture funds.

These IPOs will also cement some amazing performance for those funds who invested early and likely make early stage venture an attractive asset class relative to other asset classes. If public markets and other asset classes are down but early stage venture is performing well due to the IPOs of Uber, Lyft, AirBnB, Stripe, etc., more LPs are likely to continue allocating to this part of the asset class. It will be very interesting to see how endowments and institutions grapple with being over allocated to venture (as explained above) but the early stage portion of the asset class will likely be producing good returns relative to other investment options.

Because LPs could have significant money returned to their coffers and the performance of early stage venture as an asset class will likely look attractive relative to other investment options, early stage VCs might not have as hard of a time raising their next fund as what typically happens during downturns in the past. This in turn will allow early stage venture funds to keep deploying capital thus counteracting some of the negative effects for startups trying to raise their next round.

Third, I think we will see a continued flight to quality. We have seen this happen over the last couple years as the number of rounds have gone down but the size of rounds has gone up dramatically. This year is experiencing a record percentage of venture capital rounds totaling more than $50 million. A recession would likely only intensify this trend. The mega rounds we have seen the last few years aren’t going anywhere.

Source: Pitchbook:

Forth, seed will continue to thrive. There have been so many seed funds that have been raised and in 2019, the vast majority of those funds will still have capital to deploy. Adding to this is there is likely to be a number of new angel investors following the lock up period of many high profile IPOs scheduled for 2019. Seed funding is also the furthest removed from the public markets, so it takes longer for that stage to feel the impact. The number of seed rounds may not be as high as 2018 but it my expectation is that it will still be a very healthy market for raising seed capital.

Lastly, all this means raising in the middle will get harder. With money flocking to either end of the spectrum, raising Series A and B will get tougher. The bar will likely increase for getting these rounds done and they will likely take longer. I think startups in this portion of the market who aren’t demonstrating true product market fit and impressive growth will experience the most pain.

These factors would mean that the pressures funds traditionally face during a downturn might not be as intense in the coming downturn, if it materializes. What remains to be seen is how GPs react to their own fundraising pressures and public market conditions. VCs will continue to fund companies with good fundamentals, but startups that may not have hit milestones for their next round should budget more time to put together a round in case VCs become skittish.



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