2023 is behind us, but its lingering effects will persist in 2024 for the world of venture capital.
Over the years, I’ve observed a six-month lag between what happens in the public market and when it cascades into venture capital. So, while VC is shielded from knee-jerk reactions in the public market, persisting macroeconomic effects — or the expectation of the effects — eventually make their way down the chain.
SVB was the wake-up call of 2023.
Not many people would argue that the market was declining toward the end of 2022. But those who held fast that VC would never be touched by such a decline were quickly proven wrong when SVB fell overnight.
In over a decade, venture capital saw its quietest month in April 2023. Personally, my inbox has never been more silent, and only the worst (or most distressed) companies were in the market.
VCs shifted from a growth-at-all-cost mindset to a long-term profitability mentality almost as quickly. Founders were forced to let go of new recruits as big tech laid off employees, budgets for exploratory opportunities were cut, and capital was directed into fewer, more proven areas.
Was the end-of-year rally a signal that the bottom is over?
While the public market saw the ups and downs the entire year, the last two months of 2023 were a great rally that put everyone at ease. The Fed proclaimed that the long sought-after “soft landing” has been achieved; inflation has been beaten without the expense of recession, and rates are set to come down again as early as March 2024.
But is two months of the market strengthening enough to reverse the course of current rock-bottom venture activities?
Hardly.
Venture generally reflects only the persisting effects of the market. To be more precise, the expectations of such an effect are what drive the market since the actual effects come much later. It is difficult to predict when changes in the public market will affect VC’s expectations in the venture market, but a mere two-month-long rally alone is not nearly enough.
Still, there are other factors in the mix that can tip the equation. For example, the amount of dry powder and companies’ war chests running out.
Dry powder and (lack of) war chests are underway.
A historical amount of dry powder raised in 2022 was spent keeping portfolio companies alive, but the vast majority of it has yet to be deployed. There is still an unprecedented amount of undeployed dry powder lurking in the dark.
The problem is that no one wants to be the first, second, or third in the next rally. They would prefer to be the fourth, fifth, or sixth. Being earlier is a classic game theory problem: you don’t want to be the only one deploying hard right now.
This was partly why a lot of money was poured into Generative AI last year. VCs knew they would not be the only ones playing the game. Does this mean Generative AI was the only lucrative investment area? Not at all, but it was the only lucrative area where everyone was sure everyone else would be playing — which made it feel safer.
The other tipping factor is that most companies will run out of money this year. There has already been a steady correction in valuation over the last 18 months, and it trickled all the way to the seed stage. Eventually, prices will become low enough that the opportunity becomes lucrative again.
With the amount of dry powder still available, power has tipped back to the investor side. Existing investors cannot bridge the companies indefinitely, and some have already taken measures to do an “insider down-round” to adjust shareholder expectations in anticipation of an external round.
Companies that can raise will start raising, but not at 2021-22 valuation levels. Companies that can’t raise but can exit will exit via M&A, as bigger companies have adjusted their cash flow to a new non-zero rate reality.
So, even if it is still unclear whether we have soft-landed, it is likely that venture will stabilize in 2024 and see an uptick in venture activities, both in deployments and exits.
Election and yet-to-be-determined soft landing will be the biggest forces.
Elections typically bring a fair level of uncertainty, and many investors wait to see the result of elections before making bets. If Biden is reelected, it is conceivable that climate tech will see more spur, for example.
Thus, it is possible that the election year will drag investment activity out, especially as we get into the fourth quarter.
Now, if the soft landing has truly been achieved and reflected in the FED cutting rates, the market will have tremendous momentum. This will likely exacerbate venture capital. If such momentum rises, we could see a spur in activities that would overtake any doubts regarding the election. Venture is, for better or worse, a lemming investment game played in a small echo chamber room. Once the first domino falls, and there are enough reasons to believe the rest will fall, expectations will take over rationality.
There is currently a big timing asymmetry. Some people insist on making an “annual prediction” at the beginning of the year, but there is no good reason why we need to do so. It is far better to make the prediction as close to the tipping point as possible but still before everyone does so.
The value of prediction is, after all, getting it right before everyone else sees it. As long as you can do that, it doesn’t matter how long in advance you get it, and in many cases, it is far better to be closer to the tipping point than much too early.
