A VC cataclysm has begun. Early 2024 will be rough. But it won't change anything.
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- As 2023 winds down, a reckoning in the VC industry is underway.
- With startup failures and VC-firm layoffs, it's not likely to improve in early 2024.
- Here's how the industry set itself up for this predictable outcome.
I was on a Zoom call with a staffer for the venture capital arm of a big tech company. She's a person I've known for years.
We were chatting about life when she stopped talking, looked at her phone and said in a clipped voice, "I'll have to call you back. We just had layoffs."
Her job was safe, I later learned. But it was clear that the VC world has entered into rarified territory: people are getting fired, not because of performance, but because their industry is in a cataclysmic downward spiral.
In 2023: Y Combinator cut 17 people, it said. Sequoia Capital laid off seven staffers, about a third of its talent operations unit, it told Bloomberg. Greycroft cut five investors; and Boston firm OpenView stopped new investments and laid off most of its staff, the Information reported.
In 2023, the house of cards the VC industry had built in the previous decade — and especially the previous three years — was no longer shielded by short-term financial maneuvers. Economic headwinds had arrived.
And signs point to more challenges for at least the first quarter of 2024.
What led to trouble in 2023?
A decade-long bull market in tech accelerated into a startup-funding frenzy by 2021 (sans a couple-months scare in late spring of 2020 from the pandemic lock-down).
Opportunists, exemplified by hedge-fund turned-venture-capitalist Tiger Global, looked at the prices paid for shares in early-stage startups and wanted in.
Shares in companies that will eventually have multi-billion dollar IPOs go from a few quarters to a few dollars when they are at their earliest stages. For good reason. Picking winners before they've got customers and business models make them the riskiest bets in venture. It looks like easy money but it isn't.
"You do seed investing because you love it," one investor — who works for an established VC firm with $3.5 billion under management — told me. There's, frankly, more money to be made in later-stage investing when startups have track records, he conceded. The checks are bigger. The time-frames are shorter. That kind of investing is all about pricing.
"These early stage investors, it's like same sport, different league. It's harder [to make big money] because you are going super early, but you love the building phase," he said.
But the game-plan for opportunists was different. These investors raised mega, multi-billion funds, giving them sizable income on their 2% management fees, long before they had delivered results. Some classic VCs sounded the alarm at the time, that this was "misaligned incentives" that would cause trouble when the venture market cooled.
The opportunist's strategy was "spray and pray," getting into as many deals as they could, as fast as they could. In Tiger's case, it did hundreds of deals of year, famously took no board seats and did little to no meddling in the business itself, as traditional white-glove VCs do.
Their deal making pace caused the rest of the VC world — always subject to a bit of herd mentality — to follow. If a venture investor wanted a piece of the hot startup they were wooing, they had better offer high valuations — possibly without great due diligence, or lose out to those who would.
The whole seed fund landscape changed. Everyone wanted in. There were new fund types: rolling funds, and micro-funds. Pre-seed rounds grew as big as seed rounds. Seed rounds grew so large, they became known as "mango" rounds — as big as previous Series A rounds and so on up the stack.
Many of these startups were commanding share prices that, by 2023, couldn't be justified. I recently talked to a startup CEO who became a unicorn in 2021 and when I asked him if he would land the same now, he laughed and said, "May we all live up to our 2021 valuations."
Rising interest rates in 2022 crashed the frenzy. Cash conservation became the be-all. Investors grew stingy. Valuations fell. VCs looked at their startup portfolio and quietly, if not openly, chose which ones they would continue to support.
They helped some of those startups arrange short-term funding like bridge or extension rounds. Both of those involve committing to sell more shares at favorable prices to investors and are not ideal for startups. They can result in giving up a bigger chunk of the company at lower prices than a later deal would.
And if the startup isn't in excellent shape when that cash ran out, it will most likely be doomed, even if it had a great idea, great tech, a great team and so on.
By Q4, 2023, those 2022 extension rounds started running out, one investor told me in September. He predicated that in the last quarter of this year through the first of 2024, the startup "mass extinction" event would take place.
3,200 startups have died in 2023, along with $27 billion in venture investment, deal-tracking database Pitchbook says.
High profile, recent deaths among the unicorn ranks include Convoy, Olive and Veev.
'Dry powder' is a myth
There should have been a silver lining to all of this.
All of that money raised for VC funds during the heat of 2021 should have meant that VCs would be out there funding lots of promising startups, and at bargain prices.
But another phenom is also happening.
With the IPO market still closed, and startup valuations down, the limited partner investors in venture capital funds have been pressuring their VCs to slow their investing.
"LPs have been putting pressure on but also asking for ways to get liquidity," one investor told me.
This person says that a VC firm with $80 billion under management has created a new continuation fund — a type of fund that allows their LPs to either let their investments ride or cash out a small percentage.
This means that at least some of the so-called "dry powder" raised in 2021 is somewhat of a myth.
Yes, the LPs did commit that money to funds. Yes, by the end of 2022, dry powder (money raised but not spent) had reached a record high of about $280 billion, according to Pitchbook. Yes, if a fund puts out a capital call to its LPs, they must pay up, or face potential consequences (should the fund wish to take the politically treacherous step to sue their investors). But the LPs are the VC funds' customers. Angering them when they tell you to slow your roll to help them rebalance their assets is a death wish.
'Greed' may return in 2024
Right now, there are no indicators that we've hit rock bottom. For a shift to happen interest rates may need to drop. The IPO market may need to resume its appetite for cash-burning tech companies. The regulator environment may need to get less hostile to acquisitions from incumbents.
In the meantime, startups are facing more harpoons.
Seed investor and prolific VC industry secret-spiller, Elizabeth Yin, explained in a recent X thread how VC funds hire independent auditors to value their startups and report results to their LPs. Many LPs invest in multiple funds. Many LPs are later stage firms. Many funds invest in the same startup. So a mark-down in one fund could be seen and repeated by the others.
"Now all of a sudden the whole LP world sees that you've been written down," she wrote. And when that startup goes to raise, VCs may already be a no, even though "some of your actual VC investors may not actually think you are a bad company."
As startups fail, that brings VC funds down, making this a dangerous time for those who work in venture capital.
One of the VCs I talked to quipped, "VC is the best job ever if you're ok with living in constant anxiety with no control."
But here's the kicker. As soon as fortunes reverse — as they will — VCs will do it all over again. All the VCs I spoke to agreed. They'll invest, compete, grow frenzied, build another unsustainable bull market.
VC works in "fear and greed" cycles, one investor told me. If the IPO market opens up in early 2024, then maybe we'll be "coming out of the fear stage and the question is, are we already about to turn back to greed? I think you're going to see more greed come around, especially if some of these IPOs come around."
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