- Silicon Valley Bank released its latest State of the Market report on Thursday, and found that just 23% of currently active venture firms outlasted the dot-com bust as well as the 2008 financial crisis.
- A majority of firms have never invested during a downturn, the report found. That lack of experience could hinder those newer firms’ success in a long economic contraction, according to report author Bob Blee.
- As private company valuations trend downward, successful investors could reap outsized returns they haven’t “seen in years,” Blee told Business Insider. But they will have to act decisively to back new companies while managing the needs of their current portfolio companies.
- Older firms are more likely to have funds diversified across early and later-stage companies, which could lower their average risk and help them better manage existing funds in the long run.
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The coming economic downturn could make or break firms in the growing venture capital industry. But a new report out Thursday suggests that only 1 in 4 active firms are prepared to weather the storm.
Silicon Valley Bank’s latest State of the Markets report found that just 23% of currently operating venture firms were founded prior to the dot-com bust and thus have successfully made it through two downturns. A majority of firms, roughly 61%, were founded after the 2008 financial crisis and only know what it’s like to invest in boom times.
“It’s a different playbook in a downturn,” Silicon Valley Bank head of corporate finance and report author Bob Blee told Business Insider. “It’s one thing to read the playbook, and another to have experienced it and have helped write it.”
That experience is coming in handy now, Blee said, as the likelihood of a major, prolonged economic contraction increases by the day. The firms that have been around longer naturally have developed closer relationships with their own investor base and network of entrepreneurs, which could help influence the firm’s investing strategy over the next three to six months. Newer firms, however, won’t necessarily have the track record to usher new limited partners or entrepreneurs in the door.
A market ripe for opportunity
Venture capital acts as a sort of food chain in Silicon Valley. The limited partners, or LPs, choose which firms to invest in through particular funds, and then VCs deploy those funds by investing in startups. If one part of the ecosystem is disrupted, say if an LP decides not to back a venture firm’s new fund, that erosion of the investment capital base could have significant downstream effects.
“The returns in the last downturn were similar among firms, but the variance between the low and the high [performers] was dramatic,” Blee said. “So from the LP perspective, the experienced managers were a better bet.”
Downturns are full of those high-performing opportunities, Blee said, because the restrained market helps put downward pressure on valuations and ultimately grants investors better terms when they do decide to invest in a company. Blee said it’s the type of opportunity that investors haven’t “seen in years.”
“In these downturns, adversity drives innovation,” Blee said. “An outsized number of successful tech companies are founded, and investors can get in at valuations that are more apt to give them higher returns. The calibration is happening where they can pick up the pieces quickly and make the most out of the downturn ahead of us.”
Diversified and de-risked
Blee echoed other investors’ predictions that early-stage firms and the companies they invest in are most likely to go under because younger startups are inherently risky, even in boom times. Normally, a firm’s one or two successful bets can offset those that don’t pan out as well.
In these treacherous times, firms that have both early-stage and later-stage practices are better suited to make it out alive due to their varied investments. The less risky nature of later-stage investing can offset the potential loss from early-stage gambles.
“We don’t expect new outside lead investors will come into new companies in the next three to six months,” Blee said. “Most investors are trying to understand what is going on with their existing portfolio and how to best support them because no one knows how long COVID will be impacting us this way. It’s hard to invest in a ‘falling knife’ scenario, so most venture rounds are going to be inside rounds.”
That inherently puts later stage companies at an advantage similar to the more secure position enjoyed by late-stage investors, Blee said, because the mature companies have more investors around the table than they did in their earlier days. He explained that those companies also benefit from years of cheap funding, and are more likely to have stockpiles of cash to show for it. This also helps take the pressure off their investors to support the company financially with existing funds.
“Most firms did reserve capital for follow-on investments, but just as in the last downturn, what we are finding is there might not be enough capital to support all their companies how they want to because the capital needs just went up considerably,” Blee said. “The dynamics are different depending on the syndicated folks around the table.”
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