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In recent years, the low cost of capital allowed record amounts of dry powder to be raised and dispersed into the venture capital and startup ecosystem. As the landscape began shifting last year, we started to see a course correction by investors who had been freely pouring money into VC-backed startups. The recent bank failures introduce another hurdle into a rapidly shifting environment and dramatically highlight the challenges of our high-interest-rate, inflationary climate.
For many VCs, these recent events solidify a transition from a growth focus toward a cash flow breakeven or profit perspective on their investments. For years, there was almost unlimited cash available for startups offering hyper-growth opportunities to those on a quest to swoop up market share. Growth was to be achieved at all costs, a trend common in the technology sector.
As market conditions trended downward during 2022, VC firms increased their focus on companies already showing a profit or those with the potential to breakeven in the near future.
This isn’t to say companies with growth-oriented business models cannot find deals in the current market. We’ve already seen large closes, such as the billions of inflows into a major A.I. company in the first quarter of 2023. Capital-intensive sectors such as energy and biotech continue to attract investment, as investors capitalize on the long-term opportunities of addressing climate change and chronic diseases.
In the wake of recent banking failures, VCs will be even more conservative about how they deploy capital. We’re seeing a similar flight-to-safety trend play out among banks.
Regional fallout
Several regional markets were on the rise prior to the market slowdown, most notably cities in the Midwest and southern U.S., as the pandemic drove a major shift towards remote work and workforce mobility. The rapid influx of growth-oriented startups eager to hire top talent and forge their own paths in cities lesser known for VC activity rapidly grew these regions’ potential, even though the major hubs of the San Francisco Bay Area, New York, and Boston still led the pack.
EY quarterly data reports from the past several years demonstrate this trend. For example, Denver shot up from $2.3 billion in VC investment in 2019 to a peak of $6.1 billion in 2021. Austin went from $2.3 billion to $5.3 billion over the same period, while Miami continued its climb from $1 billion in 2019 to $5.1 billion in 2022.
The recent wave of bank failures will alter things. It could constrain these emerging markets’ growth at a time when inflation, workforce shortages, and geopolitical concerns are taking a toll. If investors and startups need to establish new banking relationships with inexperienced regional banks or national players, there could be a negative cascading effect on these emerging hubs. It will be challenging to fill this gap quickly with institutions that understand the unique needs of the startup ecosystem and can support them the way other banks have over the past 40 years.
With deep roots in the tech sector–and an understanding of its fast-growth playbook–the banks that failed had strong ties and relationships with VCs and startups. They understood these needs and aligned their products and services to help their clients achieve their ambitions. The way they served the venture and startup ecosystem propelled the innovation economy forward and played a large role in buoying great companies that have become household names. The failure of these banks may have lasting effects on the industry–and on how entrepreneurs manage cash, operate their companies, and pursue capital.
Investor-friendly dealmaking
The last few years of record venture capital investment infused startups with capital on founder-friendly terms. These advantageous deals put little short-term burden on startups and allowed them to focus primarily on growing fast and capturing as much market share as possible, with the belief that there would always be another round of capital available to continue to fuel future growth.
The market downturn and this month’s banking failures have greatly changed this equation for the foreseeable future. Now, deals will be scarcer, more investor-friendly, and take longer to close than we have seen in recent history.
For an entrepreneur who only experienced fundraising during the era of nearly free money, this can be a shock. But in truth, it’s more aligned with how deals were historically defined before the recent VC bull market began.
Now is the time for entrepreneurs to manage their resources carefully and develop viable paths to profitably and long-term growth. The companies that do this are more likely to survive, get funded and establish a strong foundation for the future.
Jeffrey Grabow is the EY U.S. venture capital leader. The views reflected in this article are the views of the author and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.
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