Some Thoughts On What's Next for the VC Industry
Valuations Down, Turnover Up, Pivots Galore
For the few who get liquid, a financial bubble is a wonderful thing. For the rest, sadly, a bubble is often most memorable for its nasty hangover.
We in tech shouldn’t beat ourselves up too much - bubbles can happen anywhere. Heck, there was a bowling bubble in the early 1960s. We can take solace that tech is a lot cooler than bowling.
The venture capital industry was a major beneficiary of the Covid-induced tech bubble. Unfortunately, that means the industry is due for a lengthy hangover period. What does this mean for startup founders?
Valuation Euphoria Is Over
Last year, extreme valuations became commonplace. Going back to 2017-2019, a 10-15x ARR multiple was common for a SaaS startup’s A or B round. Last year, SaaS startups with single digit millions revenue regularly raised at unicorn valuations: 100x+ ARR multiples! This list has 9 examples. I know of many others not mentioned.
Median public SaaS multiples are now 5-6x - so the valuation multiples of last year are gone with the wind. Many of last year’s unicorns are healthy (and have cash left over from last year’s fundraising), but it will take them years to grow into their most recent valuations. We can expect valuations to be much more modest over the next few years.
Less Carry, More Turnover
The economics of venture capital are dominated by the upside - the carried interest. Also known as “the carry.” Sure, plenty of VCs make a healthy salary. But if you polled VCs last year about their compensation expectations, there would be big numbers and they would be based on lofty estimations of future carry.
Carry can be a fantastic retention tool. If I’m a VC with an investment a few years away from IPO, that means I’m a few years away from getting a big check for my share of the carry. It’s highly likely that I will stay put, knowing a mega-payout awaits.
Last year, many unicorns and decacorns seemed on the cusp of liquidity. Many VCs had carry that seemed poised to generate windfalls - but that’s been severely deflated. A key driver of stability in the venture capital industry has been turned upside down. We can expect significantly more turnover among VCs in the next few years.
Deal Velocity Slower
The pace of VC investments accelerated rapidly in the bubble. Markup-fueled portfolios were catnip to LPs (the investors in VC funds), meaning VCs could raise new funds and start new firms at a record pace.
For almost everyone in the industry, raising the next fund is going to be a lot harder than it seemed a year ago. That means VCs must slow down their deployment pace to make their funds last longer. We can expect VCs to invest at a much more modest pace over the next few years.
It’s also worth noting that fewer investments translates into less work for VC firms. This means that many are overstaffed - especially considering less income from carry means that there will be more motivation to squeeze cash flow from the other source of VC income, management fees. This will be another force driving VC turnover.
Industry Consolidation? Not Really
In a normal industry, a brutal hangover would lead to significant consolidation. VC is not a normal industry - VC firms have no physical assets, economic incentives are unusually long-term & variable, and there are no economies of scale.
Instead of consolidation, the VC industry will likely see heightened turnover and a quiet, slow fade of many firms encumbered by out-of-the-money carry. For founders, it’s important to know:
Will the VC firm offering a term sheet today be able to raise its next fund?
What are the chances that the VC on your board is going to leave their firm and, therefore, leave your board?
While a startup can survive if one of their venture capital backers is on life support or if one of their VC board members leaves, it turns what should be an aid (a good VC backer) to a source of friction.
Pivots Aren’t Just for Startups
One thing I’ve learned about investing - and this applies to all asset classes, not just VC - is that my investing strategy going forward is likely a reflection of my best deal from a few years ago.
In the case of VCs with struggling portfolios, we can expect many to refocus around their top performing investments. If my last five investments were in four struggling software startups and one healthy hardware startup, expect me to rebrand as Mr. Hardware.
We are already seeing this with some VCs shifting away from Web3 and towards hot sectors like AI. It’s safe to bet that 2023 will see a surge of VC pivots, both at the individual and the firm level. For a founder, it’s worth asking a VC about their focus areas - is it a “flavor of the month” or is it the result of a deeply-held conviction? It’s likely the the VCs most committed to their startups’ long-term success are of the latter variety.