By Anu Shah
Covid 19 has brought unprecedented economic uncertainty across the world and tech companies think hard about the future and investments.
Especially, since the FANGs of the world are sitting on cash reserves larger than the GDPs of some countries. Infact Apple and Google are shopping aggressively for the strategic companies at a discount. For instance, Apple acquired NextVR for $100Mn, Amazon acquired Zoox for $1Bn. So what does the future of the tech start-ups and venture capital look like? To understand that let’s take a look at how does a venture capital works.
Typically, a venture capital firm raises money from the largest and most diversified institutional investors with a fund life of roughly 10 years. New investments are made in the first two to three years of a fund’s life. Venture capital creates a large reserve to make follow-on investments through the end of a fund’s term. As a rule of thumb, investors reserve $1 for every $1 invested in an early-stage company. The combination of long fund terms and dedicated reserves helps mitigate the effects of turbulence on funds and portfolio companies.
The United States venture capital industry has existed for 50 years. It has weathered many storms and is ready for anything. There the venture capital industry aggregated $275Bn in the last six years. Using both a fund-by-fund analysis and averages across the industry, it is estimated that the industry has $150Bn of “dry powder” of which likely $76Bn is earmarked for reserves for existing companies and $74Bn for new investments.
This present level of reserves is strong relative to any recent cycle. While one can be optimistic, albeit cautiously about a large reserve to help start-ups through this fundraising drought, venture capitalists will change their strategy drastically to advance further, here are some tips for the industry:
1. Be very selective about investing: Venture capitalists have invested $280bn in the last two years. In the case of backing companies at current levels, we would run out of reserves in four quarters. Hence, there will be increased scrutiny and diligence in investing, more focus on unit metrics cash flows, sustainable and profitability; over traction and growth at the expense of high cash burn; having said that, funding for innovative technologies, such as personalized medicine, online education, remote workforce solutions, and reliable Internet connectivity, will be bullish.
2. Prioritise existing portfolio companies for funding: Since 2014, more than 10,000 US companies in the U.S. that have been funded. Many companies have exited, found profitability, or already have strong balance sheets, but many more do not have alternatives and will need capital assistance. Venture capitalists will use the reserves to support their portfolio first.
3. Redirect focus on institutional investors for raising new funds: In good times, capital can come from a variety of sources including hedge funds, mutual funds, and wealthy individuals. When the cycle turns, these alternative sources can substantially pause their investing or exit the industry indefinitely, leaving only institutional investors as a primary capital source. Hence venture capitalists trying to close the new funds will double down on one channel, putting more pressure on the performance and exits of current portfolio companies. 4. Employ alternate investment and fund raising tools to continue funding: Alternate tools, such as fund recycling, that is, investing profits from old investments into strong existing portfolio companies, crossover investing, that is, investing from newer funds into older funds, and formal and informal co-investment vehicles.This will provide a boost to the industry’s reserve capacity to continue investing in the start-ups.