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Wednesday, March 15, 2023

The startup scene in Silicon Valley could face tough times in the year ahead

Silicon Valley’s startup industry is still reeling from the collapse of Silicon Valley Bank last week. And while things seem to be settling in the near term, the long-term view of the situation is far less clear, according to experts.

As of 2022, the 40-year-old bank reported that it served 50% of all U.S. venture capital (VC) backed tech and life sciences startups, leaving billions of dollars in the balance when it was forced to shut down after a multibillion dollar run on its deposits. But with the government backstopping depositors’ cash at the bank, companies are breathing a sigh of relief.

The question now is whether the shakeup will rattle the VC firms that provide funding to startups in the first place, not to mention the limited partners (LPs) that build VC’s cash piles.

“I think in the short term, it's going to be okay, from a financial perspective,” explained Columbia University Business School professor Angela Lee. “I think medium and longer term, fear is contagious. And I think that people are nervous, and it's never great to try to convince people to put money into an already risky asset class, when they're nervous.”

For startups, that means having to vie for a smaller pool of cash as LPs such as pension and large family funds ease back on funding VC firms. And if you’re running a growth company you’ll need to prove it that growth is here to stay and won’t slow anytime soon.

“If you're a growth company, if you're not growing at the rate that you had promised and set the expectation to your venture capitalists, then those companies probably will not receive follow-on venture capital,” explained Dave Mawhinney, executive director of the Swartz Center for Entrepreneurship at Carnegie Mellon University.

“But those companies that are growing, capital will become more plentiful at the rate that they promised or exceeding that then their capital is going to be plentiful for them.”

The easy money is gone

Venture capital funding has been declining since its record peak in 2021. According to Crunchbase, venture funding topped out at $445 billion in 2022, down 35% from the $681 billion it hit in 2021.

For startups that are out of their earliest growth stages, proving they can chart a path of continued, consistent growth could be the difference between another funding round to keep them afloat or nothing at all.

“The earliest stage companies that are just getting started, venture capitalists need to seed those companies with anywhere between $250,000 and $1 million, so that they become growth companies one year, two years, three years out,” Mawhinney said.

“I don't think that earliest stage is going to be affected. I don't think the companies that are growing rapidly are going to be affected. I think it's the companies that are in the growth phase, but their growth slows. They're the ones that are going to be hit the most.”

It’s likely that we won’t get a good sense of how the startup landscape will fare for a number of months. But if LPs begin to pull back on investments in VC funds, startups will know in the next year.

“I do think that institutional LPs are going to be all scared about investing in venture in the future, which means that VC funds then can't raise their next fund, which means it's going to be harder for startups to raise capital in the next 6, 12, 18 months,” explained Lee.

It doesn’t help that the tech industry in general is facing a stark slowdown compared to the growth it experienced throughout the pandemic. Stock prices are off their highs; companies including big names like Meta (META), Google (GOOG, GOOGL), Microsoft (MSFT), and Amazon (AMZN) are laying off employees; and sectors like online sales and digital advertising have fallen off.

That’s all put a scare in Wall Street as to where the tech industry is going and could add to the stress for startups in the long term.

VCs are still flush with cash

While the long term outlook for startups is unclear, the near term health of the ecosystem is still intact thanks to all of the cash VCs raised in 2021 and 2022. With billions of dollars on hand, and plenty of firms looking for investments, you can expect the VC cash to continue to flow. That said, they’ll likely be more careful with which companies they choose to fund.

“Venture capital funds raised record commitments last year, so there's a ton of dry powder,” University of Chicago Booth School of Business professor Steve Kaplan explained. “The dry powder…is conservative because we're in a recession, which is normal, but, that dry powder will get invested”

The startup scene is also in the midst of a kind of artificial intelligence gold rush thanks to the popularity of OpenAI’s ChatGPT, Microsoft’s Bing, and Google’s upcoming Bard. That’s giving plenty of VC firms a tantalizing trends to jump on at a time when they’ve got the money to spend.

We’ll likely learn more about where VCs will spend their reserves in the coming weeks and months. But what’s clear for now, at least, is that the innovation in Silicon Valley will continue to move forward despite the collapse of Silicon Valley Bank and the fear it’s spreading through the markets.

By Daniel Howley, tech editor at Yahoo Finance. Follow him @DanielHowley

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