What the Decline in Venture Capital Funding Means for Entrepreneurs

Startups largely live and die by the amount of funding received, and over the past three years there has been an onslaught of investment that virtually doubled as 2015 came to a close.

But that rock-solid growth is beginning to show cracks, as the number of startups that received funding, and the level of funding committed, fell by 11% in the first quarter compared to a year ago, according to the recently released MoneyTree Report from PricewaterhouseCoopers LLP and the National Venture Capital Association, based on data from Thomson Reuters.

Venture capitalists sunk $12.1 billion into 969 startups in the first quarter, down from the nearly $13.7 billion raised a year ago in 1,085 deals. And should the rest of 2016 continue on a similar path, it will fall far short of the $59.7 billion invested in 2015 in 4,497 deals. Unfortunately for the industry, venture capitalists and industry experts are expecting just that in 2016.

“I think we are seeing a slowdown compared to 2014 and 2015, but it will get to the levels that we were more used to,” says Tom Ciccolella, U.S. venture capital market leader at PwC. “A more normal amount raised would be less than $40 billion.”

And over the past 20 years, the number of companies that have received venture funding has averaged about 4,000 annually, or about 1,000 a quarter, Ciccolella adds.

Fall from Record Highs

The number of deals funded in the first quarter was slightly softer than the historical average of 1,000 a quarter. Additionally, the number of mega-funding deals, where a startup receives $100 million or more in a quarter, fell sharply in the first three months of the year, Ciccolella notes. The first quarter garnered 10 mega-funding deals, including a $1 billion funding round for ridesharing company Lyft. But the number of mega-funding deals is down from approximately 75 last year and 50 in 2014, Ciccolella says.

Other events that helped to slow the funding rate in the first quarter included less demand from previously funded startups.

“When you go around [Silicon] Valley, one of the reasons why deal flow is down is a lot of companies are sitting on a big chunk of change,” Ciccolella says. What’s more, when comparisons with today’s levels are being made, it’s worth keeping in mind that recent years “have seen record-high levels of fundraising.”

Additionally, non-traditional investors pulled back on startup funding in the first quarter, a segment of non-venture capital investors that includes hedge funds, private equity firms and corporate investors. Part of the pullback from non-traditional investors was attributed to a refocusing on investors’ core businesses, according to the MoneyTree report.

Luke Taylor, a finance professor at Wharton, notes that non-traditional investors have largely been involved with the more mature, late-stage startups. “If these investors walk away, it won’t have much of an effect on early-stage companies. Will it affect late-stage companies? Possibly, but possibly not too much.”

The greatest impact will likely be on companies that are taking their time going public in an IPO. Without the added support of non-traditional investors, some of these companies may want to access the public markets sooner rather than later, Taylor adds.

Sizing up 2016

That pullback from non-traditional investors is expected to accelerate during the rest of the year, says Venky Ganesan, a managing director with Menlo Ventures. “I expect traditional VCs to continue life as normal. The non-traditional players, hedge funds, sovereign wealth funds, etc., will however transition from the market.”

The Fed’s signaling of a rising interest rate climate will likely make it more attractive for these non-traditional investors to consider re-allocating their funds toward interest-related investments, rather than startups.

Tim Draper, founder of Draper Associates, DFJ and Draper University, expects the level of funding to remain flat or decline 5% quarter over quarter for the remainder of the year. But valuations are likely to rise 20% during the year.

Potentially helping to prop up valuations: a strong market and the debut of successful IPOs. According to Renaissance Capital, a manager of IPO-focused ETFs, the improving market conditions may bode well for four IPOs slated to raise nearly $1.5 billion.

Meanwhile, unicorns — startups that carry a valuation of $1 billion or more in private markets — may see their herd thinned in the current year as investments in these high-valuation companies becomes more realistic, as suggested in this Knowledge@Wharton article in January.

Venture capitalists who invested in late-stage startups like unicorns received a wake-up call in the first quarter. “Growth at all costs was no longer acceptable, and unit economics started to matter again,” Ganesan points out. “There has been a significant pullback in late-stage and expansion deals, and you will see it in the data in the coming months.”

Late-stage and expansion investments already fell 23% to $7.5 billion in the first quarter, compared with the same time a year ago. That is in sharp contrast to seed- and early-stage investments, which rose 17.7% to $4.6 billion in the quarter compared with year-ago figures, according to the MoneyTree report.

“Unicorns got slightly ahead of themselves because there was so much excitement about their brand sizzle. I think valuations are about right now,” says Draper. What’s more, most unicorns are very well funded and are not actively searching for more money right now.

Strategies for Entrepreneurs

With a tightening funding climate likely to engulf startups this year, should entrepreneurs be worried?

“They should absolutely be worried,” says Taylor. “There’s a lot of uncertainty right now about how hard it will be to raise VC money in the future. Most of these companies will run out of cash and shut down if they fail to raise VC financing.”

Not only should entrepreneurs be concerned, but they should also be taking action, says Ron Berman, a professor of marketing at Wharton, who has written a paper on the effect of expenditures on a startup’s survival.

“In general, it would be advisable for entrepreneurs to do one of two things,” notes Berman. “If they are about to finish fundraising, they should aspire to raise a larger amount than planned, since the next opportunity for fundraising may not come soon. This strategy is different than the past strategy of raising a very small pre-seed or seed round, getting traction and then going for larger rounds.”

However, if a startup is not currently in the process of raising funds or is unlikely to do so in the near future, then it’s important to prioritize sales and validate the business model rather than spending money on research or product development, Berman advises. The ideal behind this strategy is to either improve the startup’s operations or generate sales through marketing.

But many entrepreneurs, nonetheless, still believe in building a minimum viable product (MVP), then raising the funds to build it into a full product, Berman explains. This strategy may work for a quickly growing services startup, with a proven business model from day one. However, if that is not the case, the startup should focus on the business model, as well as the customer purchase process and the value chain.

A value chain determines how value is created by the startup’s product or service, adds Berman. For example, under Uber’s value chain, the driver receives some value in the ability to utilize his or her idle car and phone to earn money. For Uber’s customers, the value is the lower-cost of travel, more availability of cars and the ability to use a phone to hail a ride.

In analyzing the value chain, a dollar value is placed on each of the driver and the passenger values.

“Many startups create a service which is very useful for customers, but they are actually not willing to pay much for it – hence, there is a chain of producing a service or product, but it has little value,” Berman point out.

Areas Grabbing VC Attention

Software has historically grabbed the largest slice of venture investment, and in the first quarter that remained the case, according to the MoneyTree Report. Software startup investments accounted for 42.1% of the $12.1 billion invested.

Over the past two years, investments in the Internet of Things (IoT), bots, virtual reality and augmented reality have been strong, says Ciccolella. “The fourth pillar of the technology change — from the PC to the Internet to mobile — is augmented and virtual reality.”

Draper also cites IoT as a hot sector that is attracting VC attention, as well as areas that he specifically likes such as technology for government agencies (GovTech), financial services (FinTech) and the medical industry (MedTech).

Ganesan, meanwhile, favors messaging bots, cyber-security and drone-related investments. But there is one area that he considers bulletproof when it comes to weathering shifts in the economy: “The most macro-proof sector will be (software-as-a-service) SaaS, since that has recurring revenue, which is predictable.”

And at the seed-stage level, health technology, analytics, social media and ecommerce are the type of startups that frequently pitch to the M&T Innovation Fund, which is supported by the University of Pennsylvania and the Jerome Fisher Management and Technology Program.

The fund, a student-run operation within the M&T program, provides non-equity cash grants of up to $4,000 to startups run by current Penn students or recent M&T alumni, said Robert Lawrence, co-head of the fund’s investment team. Since the fund was created in 2015, it has invested in 10 startups. The fund aims to invest in five ventures each year.

In assessing the overall climate for VCs, Berman says the slowdown in funding may not necessarily be a bad thing for startups. “This will make firms more resilient, and will make sure better deserving firms get funded. The outcome will be actually less competition among startups once they get funded, because less firms get funded, and that capital is spent more efficiently.”

Knowledge@Wharton