Venture Capital Has Dried Up: What Now?

It’s been four years since Covid-19 pandemic started and news was popping about how the venture capital (VC) industry was slowing down. The doom and gloom portrayed around the media coincided with a global economic slowdown and geopolitical tensions.

Typically, a funding crunch occurs when the Federal Reserve hikes interest rate. This creates a multiplier effect in the economy, including:

• reduction in investment, as cost of capital has increased, making borrowing expensive, but saving more lucrative. So limited partners (LPs) may find it lucrative to invest in long-term deposits and T-bills rather than invest into VCs, which are significantly riskier.

  Remember, the more you save, the more money is at your disposal for investment.

• lower valuation for startups due to less funding available, startups are assessed with greater scrutiny and valuations will be slashed.

• delays in raising are common for startups, as VCs may perceive startups with more risk.

  This has occurred from particularly 2023, where Crunchbase wrote that VC dropped by 38% from 2022 ($462 billion to $285 billion).

Several more effects may be attributed as a result of less funding available.

• focus on later stage companies and profitable bottomlines, which may favor VCs reduced risk appetite but starve early-stage companies of much needed capital. Throughout 2023 we have seen an interesting trend for late-stage deals - the number of deals have remained relatively stable and have not tapered off as much, but the total value of deals have fallen.

  Observation: Late-stage deals are far less in numbers than early-stage deals. So the drop-off wasn’t as much as early-stage. If you see the graph below, late-stage deals fell 20% from 2022, and 25% from 2021.

• less exits with IPOs or mergers & acquisitions due to high interests making bonds more attractive for investors to invest in. Also higher borrowing costs lead to less money available for investors to merge or acquire startups. We can clearly see that startups were acquired 31% less in 2023.

Where do startups get funded from?

Looking across my workspace I see a bunch of bustling startups trying their best to attract VC attention. I hear the term “fundraising” often in their conversation and it feels wrong to see their efforts to in vain. Unlocking business potential should be a net positive of a prosperous economy but somehow we have ended up in the trenches of digging for scraps .

How do startups get funded?

Looking at the fundraising situation globally, you’ll see that VC funding is consolidating more late-stage deals over early-stage ones. This means VCs are leaving early-stage startups behind and chasing safer bets.

The ones that are left to pick up the pieces are:

Accelerators and angel investors.

Accelerators are structured programs that fast-track your startup’s growth within a fixed timeframe. Accelerator programs are held for 3-6 months. They are tailored for early-stage startups, typically in the pre-seed to seed stage of funding. How many accelerator programs do we have worldwide? Aljalahma & Slof (2022) says there are 8,000 business accelerators worldwide, half of which were launched between 2014 and 2020 (Davidson, 2021).

Why do I think accelerators make a great case for filling the startup funding gap? Because globally early-stage startups going through a funding crunch for startups from VCs. Where will the funding come from? Hawari-Latter, Bruce and McNicoll (2021) argue that there are great benefits to accelerators in maintaining the entrepreneurial ecosystem so that startups can get the crucial pre-seed or seed funding they need to jumpstart their venture.

How much money have accelerators attracted? $50B by 2018 (Gliet, Hoicka & Jackson, 2018). That’s still 6 years ago. I couldn’t get any new data on this because journals published on this seems to be an ongoing process. This figure was less than $5B in 2014.

Why have accelerators attracted 10x the capital in just 4 years? It seems that the efficiency of these programs have attracted investors in bulk to seek the ‘packaged’ model of startups that are ready for growth at scale.

Also, interest rates over this period hovered between 0.25% to 1% between 2015 to 2017 which led to a boom in borrowing and crunch in fixed deposit investments leading to more money being available in supply. With the right promotion at the right time, accelerators were able to attract a large sum of capital from investors looking to gain a bigger ROI from their investment.

Angel investors are high-net-worth individuals that invest into early-stage startups. They typically have a minimum of $1m to $5m of liquid assets that can be converted to cash quickly as possible. These include cash, bank accounts, investment and bonds. Angel investors are the backbone of early-stage startups, typically investing when the business is from ideation, MVP and early-stage revenue.

Angel investors look o diversify their wealth. They typically invest from the safest financial assets to the riskiest. Early-stage startups fall under risky investments. They are either active investors of startups or they are sought after by the community. When they are active, they may aggressively pursue investment at a favorable valuation whereas if they are sought after, they may ask for a bigger discount so they have more skin in the game.

What should be the terms of raise?

SAFE notes are the typically the best method of seeking accelerator or angel investment. In fact accelerators are pre-seed or seed VCs if they are providing funding. Both of them may also ask for direct equity in the startup, depending on their appetite for risk.

The startup’s future maybe shaped by a board seat which the investor may seek from the business. If the investor seeks a board seat then the question arises on what is the minimum investment ticket size that a founder should set in order to give the investor a board seat. Also, what is the profile of the investor? Do they add value to the startup’s niche so they can scale further? Considerations before a board seat may be about two things:

1. They should invest a minimum ticket size. Now this depends on how many investors are raising in the round. If it’s pre-seed and you are raising $150k and the investor invests all of it, it’s fair to ask for a board seat. However, if they are only chipping in $25k, the next question should be,

2. Evaluate what value the investor is adding. Would they connect to customers, vendors, or future investors such as VCs for the startup? Would there be a key affiliate in the angel investor’s network that can further help scale the business with efficiency?

Startups who are raising also have the option of raising from friends and family. Typically they are smaller checks between $5-25k and have the best option of fueling the earliest needs of the founder like hiring a tech team, renting an office space and marketing for customers.

We are entering into an era of consolidation in the VC industry. This is leading to a lot of changes in how startups are raising their funds. A gap is being created in early-stage fundraising and the investors that have to step-in to fill that gap are going to be angel investors and accelerators. The global ecosystem should create more platforms for startups to raise capital while frontier markets where I operate like Bangladesh needs to see a lot more activity in educating what angel investment does for job creation and the economy.

If you have are an active angel investor and would like to invest into good founders with a solid idea, please get in touch at [email protected].