Authors: Rob Price, Ben Bergman, and Melia Russell
Silicon Valley is bracing for what it fears will be an “extinction event” threatening the survival of hundreds of startups.
After an unexpected COVID-19 era boom, in which startups nearly doubled what they raised from venture capitalists — and the subsequent bust due to rising inflation and lingering supply chain issues — the economic landscape is dire for many venture capital-backed tech businesses. While these pandemic-era funding rounds helped buoy many startups, investors, entrepreneurs and industry watchers believe that the party is now officially over for Silicon Valley — and they’re worried about how the hangover is likely to get much worse.
The data, they argue, shows a perfect storm of factors that will prompt an abnormally high wave of startup failures: A drought in venture capital is spreading through the valley as VC investments into startups drop for the sixth consecutive quarter. Similarly, venture debt, another funding source, has cooled since the start of the year. The IPO market has also shriveled, taking a once-reliable escape route off the table.
Meanwhile, tech companies permeate throughout every industry and there are more startups in the market than ever before. But huge numbers of them have less than 12 months of run-way in the tank.
All this means that founders in need of cash are now facing a precipitous drop in the amount of investment available to them.
“Many startups won’t see the funding that they rely on to continue,” said Jennifer Neundorfer, a general partner at early-stage investment firm January Ventures. “I do think that this is a Darwinian moment for startups.”
Some fear this crisis may be worse than the “dot-com” crash of the early 2000s
In March 2020, the influential VC firm Sequoia Capital warned the pandemic could cause economic instability and resultant issues for startups — from a drop-off in VC funding to weak sales and painful layoffs.
But despite the initial panic the “Black Swan” event, as Sequoia called it, didn’t materialize. US venture-backed companies actually raised $329.9 billion in 2021. That’s nearly double the previous record of $166.6 billion raised in 2020. (In 2022, that had fallen to $288.3 billion, most of which was raised earlier in the year.) It turned out that keeping people locked inside and glued to their screens was a huge boon for tech companies.
Venture capital is a cyclical business, but investors say that boom helped suppress startup failure rates, because companies found it easier than ever to access capital when they needed it.
However, the afterglow of the pandemic’s huge funding rounds is waning and another analogue is echoing through the valley: The infamous “dot-com” crash of 2000, where a generation of internet startups collapsed because they were overvalued and wildly unprofitable after growing on the back of huge venture capital investment.
Tom Loverro, a investor at 40-year-old Bay Area venture capital firm IVP, has been loudly warning for months on Twitter and in media interviews about a coming “mass extinction event” for startups. But Loverro believes because of tech’s size and ubiquity across industries today, the upcoming crash may actually be far worse than the 2000s.
“The total number of companies that will ultimately do down rounds, go out of business, that sort of thing, will be greater this time around,” he told Insider.
The data suggests a blood bath is coming
Over the last year, the mood in Silicon Valley has darkened. Rampant inflation prompted the United States Federal Reserve to raise interest rates to its highest levels in 15 years. The spectacular implosion of Silicon Valley Bank — a key funder and financial institution for many tech firms — shook the industry. Now, investors and industry observers are nervously eyeing an array of concerning data points.
The total volume of venture capital investment into US startups has slumped for six consecutive quarters, according to data firm Pitchbook. Venture debt — an alternative funding source for startups that doesn’t involve equity — has also dropped, it found.
Startups are already feeling the squeeze
Almost as soon as Linda Ahrens, the cofounder and CEO of startup Unown, started looking for Series A funding for her fashion startup, she could tell something had changed.
She had previously raised around $2.5 million in seed funding in 2019. Ahrens started trying to raise new capital to fund the company’s expansion and extend its runway in the fall of 2022. Initially, Unown took some “bridge” funding from prior investors to tide it over. She returned to the search in earnest at the start of 2023.
But investors whom the German entrepreneur knew weren’t answering her calls. Her business was hitting its goals, but all of a sudden no-one was interested. Even a last-ditch slashing of the startup’s prospective valuation — a “down-round,” in Silicon Valley parlance — didn’t whet investors’ appetites.
“When I went out again in January, this is when it became super difficult,” Ahrens said.
Without a fresh injection of capital, the future of the 20-person company was suddenly in jeopardy. Unown filed for provisional insolvency in February, a process when a German business’ prospects are in doubt, before ultimately declaring insolvency in May after efforts to sell the business outright went nowhere.
“I still believe that we had something, and we — especially, we had something that created impact and we had the numbers for it,” she said. “If the timing had been different, we would have had a shot.”
Over the past year, many startups that rely on Silicon Valley funding have been steeling themselves for the slowdown to avoid similar fates.
Headcounts have been cut. Focus has shifted to profitability. Some startups raised more funding than they needed in anticipation of coming capital scarcity. But it may not be enough.
There have already been some high-profile flame-outs in 2023. Robot-pizza startup Zume couldn’t make it despite $500 million in venture capital investment. Fintech firm Plastiq has filed for bankruptcy. The search engine Neeva sold itself to Snowflake, a cloud-based data warehouse firm that went public in 2020.
But many industry-watchers believe the second half of 2023 is when the failure rate may start to tick up properly.
“I will say, I do think the worst is yet to come,” Pitchbook analyst Vincent Harrison said. He pointed to the vast funding rounds throughout 2021 and early 2022, and the 12-24 months of runway many companies secured in them. “A lot of those companies have yet to even return to market or attempt to return to market to raise capital.”
This winter, EV company Arrival cut about 50% of its staff. In the spring, RapidAPI, which was previously valued at $1 billion, also laid off half its team. On Twitter, investor Elad Gil called recent startup layoffs a ” “Canary in the coal mine for what is coming.”
Starting to see more and more 40-50% layoffs (after prior rounds of “13%”)….
Canary in coal mine for what is coming
— Elad Gil (@eladgil) May 8, 2023
Who’s at risk? Businesses that are offering less-vital software services may be vulnerable as their clients cut discretionary spending, Jennifer Neundorfer said. Crypto startups that raised vast sums before their idiosyncratic bubble popped may also be in the firing line.
Gené Teare, a senior data editor at startup-tracking service Crunchbase, predicted one exception: Startups focused on AI. While the overall failure rate will increase beyond the historic norm, the buzz around AI may allow these firms to flourish.
By and large though, experts think it’s less about the sector than the business model: Is the company generating real revenue? What’s its burn-rate like? Are existing investors willing to prop it up?
“Companies with no revenue are most at risk,” Steve Brotman, Managing Partner at Alpha Partners, told Insider. Brotman believes venture capitalists will shift their strategy to support their existing portfolios or companies that already have a potential to generate large revenue. Growth stage firms may also survive, albeit with restructured ownership and a lower valuation.
Some are rejecting the predictions of an “extinction event” for early stage startups entirely.
Will Hawthorne, founder of startup M&A advisory firm Avid Capital Advisor and partner at VC firm Sugar Capital, pointed to the hundreds of billions of dollars of unspent capital that investors are sitting on. He argued this “dry powder” could help alleviate the potential economic pain of the coming months.
“Everybody always says: this is the end, this is it. And then we get into one of these boom cycles again,” he said. “The pricing may be different. It may be a little slower than it was over the last three years, but VC’s been around for a long time and we continue to innovate in America. “
Companies will have to show commercial success
Tom Loverro recently got a call from a CEO at one of his portfolio companies. The company had gone through a painful round of layoffs, and the chief executive wanted Loverro to come in and help rally the troops.
The Menlo Park-based investor joined a company all-hands, where he explained the tough economic climate — and what it meant for the startup itself. His advice was simple: startups now have to prioritize their goals and focus on what matters most to the business. “And so what that means is: You can’t do everything — at least at once.”
His guidance also points to a potential way through for businesses trying to weather the crisis: Clear focus and fiscal discipline.
“Funding successful innovation is not dead, but companies need to deliver tangible milestones and commercial proof points in order to survive,” Mike Ryan, the cofounder of BulletPoint Network, a firm that analyzes startups, told Insider.
Bridge rounds, as Unown initially did, are also becoming increasingly popular and accounted for at least 40% of all investments in Series A and Series B in the first quarter of 2023 — a post-pandemic record.
Other businesses and investors are changing their perception of what success looks like during an economic downturn. “I’ve been hearing that raising a flat round is the new up round,” quipped Pitchbook’s Harrison.
But other entrepreneurs are already on the receiving end of a more uncomfortable message from investors and advisers: Sell now and recoup some capital, rather than limping on for another few months in vain. They might even find a home for their product and team if they can woo a potential buyer before cash runs out.
“Smart VCs look at the company and say: You’re out of money in six months and the writing’s on the wall,” said Hawthorne. He believes entrepreneurs should proactively think about being acquired or finding another exit strategy.
Even if failure is inevitable, throwing in the towel is acutely painful for any founder.
“It’s tough on a personal level because I feel like this is what I spend so much time on, but I also know that within that period — right, in this time — we created impact,” said Ahrens, the Unown cofounder.
“It’s super hard to stand in front of your people and tell them: This is it.”
Full article can be found here: https://www.businessinsider.com/silicon-valley-fears-exctinction-event-startup-failure-rate-increase-2023-6