The Smarter Startup

Understanding the VC Cycle

The venture capital industry is cyclical and ultimately self-correcting. Be patient if you can, better conditions are not far off.

Evidence of the venture capital industry’s current pullback abounds, from the steep decline in VC financings to the growing stories of startup failures. The former leads the latter, naturally, and an entire generation of startup founders is learning just how cyclical the venture capital industry can be.

As the current leg of the cycle unfolds, it’s very important for founders to understand the bigger, more historical picture. VC capital, or rather its availability, has ALWAYS oscillated between irrational abundance (think anything related to fintech or crypto 18 months ago) and miserly restraint (pretty much any pre-revenue seed-stage startup right now).

VC capital, or rather its availability, has always oscillated between irrational abundance and miserly restraint.

Into this mix comes complicated drivers of capital – interest rates, financial markets, alternative investments, even FOMO (especially FOMO). To coin a phrase, more money has been lost chasing the latest coolest financial trend than from the point of a gun.

This is normal. The ups and downs of traditional cyclical industries – oil & gas, real estate, etc. and yes, VC – are ultimately self-correcting. They move like giant sine waves, with each leg containing the ingredients for the next. For instance, take copper – as demand rises during the early stages of an economic expansion, mines are called on to produce more copper. This increased demand induces mines to produce as much copper as they can, and encourages new mines to come online. Together, this raises supply in the market and (eventually) results in lower prices. Predictably, those lower prices ultimately squeeze less competitive mines, many go out of business or stop production, and supply is reduced. What happens next? You guessed it – prices rise on the newly constrained supply, dormant and new mines come back online, supply goes back up, prices drop – and the whole cycle starts over again.

Availability of VC Capital is Cyclical

From a macro perspective, VC and the startup community it supports go through a similar cyclical progression. When capital is abundant/cheap, too much money chases too few deals, FOMO reigns, and standards, terms and covenants are relaxed in order to put capital to work. Valuations are high, bad deals are made, and untenable business models financed. Conversely, when capital is scarce/expensive, too many deals chase too little money – valuations are low, startups struggle to raise capital, those with unpromising ideas or no traction are weeded out, and “supply” is removed. VC standards, terms, and covenants tighten.

A cardinal difference between the VC cycle and the copper example, however, is how it relates to startup valuation. With an industrial metal like copper, price is related to the material being sold, and per traditional economics, the more of it there is, the less a unit of it will cost (and vice versa). With the VC/startup ecosystem, capital is actually the supply driver of “price”, which in this case is valuation, and they are directly correlated to each other. When capital is widely available, either through low interest rates or changes in investment preferences, startup valuations go UP, not down, and the fundraising environment becomes a seller’s market. When it’s not – i.e., when capital is expensive or less available, startup valuations go DOWN as founders try to attract/incentivize investment. This shifts the ecosystem to a buyer’s market, making the cycle counterintuitive compared to others. It’s not the number of startups that primarily drives valuations up or down, but the amount of capital looking to finance them.

Takeaways for Founders

The environment we’re in at the moment is not a new one, nor is it permanent. Cycles in VC typically move much faster than more industrial ones, like the copper example, that need long lead times to increase and reduce supply, so peaks and valleys are relatively transient. Secondly, the startup community has always bounced between feast and famine – either anyone and their brother can raise money, or no one can. Be patient if you can – better conditions are not far off. When it comes to fundraising, know where you are within a given cycle – 18 months ago, startups without much going for them were able to raise significant amounts of capital at the Seed and Series A stages, while those raising now are finding terms are tough, deal screens are tight, and valuations are lower than they’d like. Unsurprisingly, characteristics like revenue and positive EBITDA are favored over growth for the time being, so prioritize them.

A Final Observation

The VC cycle shifts quickly and often without much fanfare. Don’t raise more than you need right now, under depressed terms, since you may be able to raise again under better conditions fairly soon. Often, the public equity markets set the pace – as stocks recover from a recession (or the fear of one), VC terms begin improving, and valuations start to rise. If the past several months are any guide, we may be past the bottom, and conditions in the startup ecosystem will begin improving this fall. Startups looking to raise capital late this year or early next should therefore start getting financial models, scenario plans, and product roadmaps ready now, ahead of the next wave.

Our team of highly experienced fractional CFOs have seen dozens of VC cycles between them, and can help get you well positioned for the inevitable upswing promised, for better or worse, by the cyclical nature of the VC industry.