VCS Brakes: When Will Venture Capital Slow Down?

A Shift in Perspective: When Will Venture Capital Slow Down?

The intention is to avoid simply becoming a source of repetitive market commentary. This column aims for more than just reacting to daily stock fluctuations.

Therefore, we are altering our usual approach today. We will examine a different angle regarding the current financial landscape.

Focusing on Venture Capital Activity

Typically, The Exchange focuses on startup news, market trends, and financial matters. It’s a regular feature on TechCrunch+ and available via a weekly newsletter.

Rather than analyzing public market performance and its potential effects on startup valuations, we are shifting our focus. We will investigate the point at which venture capitalists might begin to curtail their investments.

The question isn't if VCs will slow down, but when. Several factors are converging that could lead to a decrease in funding activity.

• Economic uncertainty is increasing globally.
• Public market valuations are experiencing volatility.
• The fundraising environment for VCs themselves is becoming more challenging.

These conditions collectively suggest a potential pullback in venture capital deployment. Understanding the timing of this shift is crucial for both startups and investors.

Monitoring key indicators, such as deal volume, average deal size, and the pace of fundraising, will be essential. These metrics will provide insights into the evolving behavior of venture capital firms.

Ultimately, predicting the precise moment VCs will “hit the brakes” is difficult. However, by analyzing current trends, we can gain a clearer understanding of the potential timeline.

Assessing a Potential Slowdown in Venture Capital Activity

The prevailing opinion has consistently been that the availability of inexpensive capital, driven by globally low interest rates, significantly contributed to an unprecedented influx of funds into the startup ecosystem. Consequently, both the size of venture capital funds and the scale of startup funding rounds experienced substantial growth.

This surge in investment led to increased costs associated with acquiring stakes in startups throughout their development phases.

While not universally welcomed, venture capitalists aren't necessarily pleased with the current valuations, often paying 75x, 150x, or even higher multiples for shares in early-stage companies. However, the prevailing market conditions, dictated by factors outside of their direct control, have largely shaped their investment strategies in recent years.

The central question now – and arguably the most critical for the startup landscape in the coming years – concerns the future trajectory of these investments. The incentives that have guided venture capitalists over the past decade are beginning to shift, with a projected substantial increase in the cost of capital this year due to tightening monetary policies. This shift is already manifesting in declining valuations for riskier assets, such as highly valued technology stocks.

Practically, this signifies an inverse correlation between the cost of capital – determined by key central banks like the U.S. Federal Reserve – and the valuation of startup exit opportunities.

The underlying principle is straightforward: Startups are initially valued based on potential (at the seed stage), then on growth trajectory (Series A through C), and ultimately by comparable exit valuations (late-stage). Venture funds prioritize exits occurring in the later stages, making the public market valuations of comparable technology companies particularly important. More expensive capital increases the attractiveness of bonds and other lower-risk investments, diminishing the pricing power of startups. Therefore, as the cost of capital rises, the exit value of startups tends to decrease.

This impact will eventually extend to earlier-stage startup valuations, a dynamic we have observed previously.

Considering these factors, the question remains: when will venture capitalists begin to moderate their investment pace? Currently, the answer appears to be not yet, for two primary reasons:

• Significant institutional momentum stemming from already committed funds, coupled with a desire to support promising companies that could yield rapid returns to satisfy Limited Partners (LPs), the investors in venture capital funds.
• A conviction that the companies being developed today possess substantial long-term value, potentially outweighing any short-term market volatility affecting valuations.

The momentum from existing commitments is a considerable force. Venture capitalists have already secured substantial new funds that they are obligated to deploy. However, the belief in long-term value is more susceptible to change. This suggests that a shift in investor sentiment, rather than factors like reduced venture capital pools, will be the primary catalyst for changes in startup investment activity – and consequently, pricing.

Therefore, we can anticipate a change in the venture capital market when investor concern regarding high startup valuations relative to potential exit prices surpasses investor FOMO (fear of missing out).

If startup failure rates are declining and the long-term prospects for new technology companies remain strong, short-term greed is justifiable, as the long-term market is expected to reward successful ventures regardless of daily stock market fluctuations. This environment encourages FOMO, leading investors to rationalize nearly any deal that appears promising.

The specific event that will erode this confidence is uncertain, but potential triggers include a continued decline in public market comparables for startup exits, an increase in withdrawn or postponed IPOs, and growing reluctance among crossover investors in final funding rounds.

As of now, these conditions have not materialized. However, a recent article in The New York Times highlights the current state of mind among startup investors, questioning the dynamics within the venture capital landscape. A brief excerpt:

With this perspective, it becomes challenging to dissuade a venture capitalist from paying a substantial multiple for a startup today – it could evolve into the next Microsoft.

It’s also reasonable to question how many tech companies will ultimately achieve trillion-dollar valuations (a negligible number compared to the total number of startups) and how many are currently valued as if they will reach that level (potentially the entire late-stage market).

This dynamic can be succinctly illustrated as follows:

A preference for optimism over caution. Until caution prevails, the current environment favors FOMO in startup investing. After all, it’s easier to justify decisions when they appear successful. Admitting a shifting landscape is more difficult when one currently occupies a position of leadership.