Only one out of every 10 startups survives, said the old adage. But that was far from the case during the boom years of the last cycle when company failure rate was low—very low.
Miguel Luiña, managing director of fund investments at Hamilton Lane said,
"VCs expected a certain percentage of their portfolio not to make it to the next round, but [company survival] has been off the charts."
He added that for certain managers, almost 100% of their companies raised subsequent funding during the capital-rich era that ended last year.
The number of VC-backed companies filing for bankruptcy or shutting down has hovered around 1,000 per year since 2016, according to PitchBook data. At the same time, new startup formation has increased, as measured by first VC financing, greatly exceeding startup failures.
Staying alive
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But the years of low startup mortality are coming to an end.
Last week, Wyre, a nearly 10-year-old blockchain-based payments company, reportedly told employees that it is going out of business. A couple of days later, The Wall Street Journal reported that Genesis, a large crypto lender, is considering filing for bankruptcy protection.
While last year's valuation correction has yet to force many companies to close their doors, investors expect the shutdown rate to shoot up dramatically in the second half of 2023 and into 2024.
Micah Rosenbloom, a co-founding partner at Founder Collective said,
"I think loss ratios will be triple—or some big multiple of what they've been."
The most severe ramifications of the slump are taking a while to manifest for several reasons.
Startups entered the downturn with a decent amount of cash that allowed them to continue operating, and investors did everything possible to help their portfolio companies stay alive by providing bridge financings or helping them secure venture debt.
But most venture capitalists won't be as supportive of their weaker investments this year, as they seek to protect existing capital commitments.
Yash Patel, a general partner at Telstra Ventures said,
"In 2022, [VCs] put money in a lot of companies that probably they shouldn't have."
Last year, there was still "hope" that many struggling startups could be kept alive, but now it looks like VCs may have been throwing good money after bad, Patel said.
"Investors are going to get very strict about their reserve allocations, saving [funds] for the best winners."
While the number of shutdowns is still low, high-profile closures are on the rise.
So far, the prominent shutdowns have been in the battered crypto space, but investors expect failures in other technology areas.
As to what kind of businesses will go under, VCs are not singling out specific verticals.
Rosenbloom of Founder Collective said,
"I think it's going to be companies that just either didn't realize how hard this is going to get and could not get control of their burn rates."
COMMENTARY: At end of Q3 2022, Venture capital activity measured by exits is down against the historic levels achieved in 2021 and Q1 2022 but still well above historical averages. At the same time there has been a uniquely positive aspect of 2022 for the venture industry with US and global “dry powder”—funds available to be invested—standing at a record $572 billion globally and $290 billion in the US.
Today, VC funds are very well stocked to make rounds of new investments at much healthier valuations compared to one year ago. However, the dramatic valuation gains of the last five years mean established venture investors are typically overexposed within portfolios (“the denominator effect”), pausing on new allocations. At the same time, new institutional venture investors are appearing, especially in family offices, foundations, and endowments (along with their outsourced CIOs), all assessing how to build venture exposure for decades to come.
Lessons From Past History -- Technological Innovations Always Wins
It’s almost over-written that recessionary times bring out the best in exceptional entrepreneurs and young companies. Like an ice bath to a strong athlete, the shock from rapid change in the environment forces rapid adaptability and resilience while narrowing operating focus and creativity.
During recessions the strongest startup companies are quicker and more adaptive to:
- Cost efficiency needs.
- Customer acquisition gets cheaper.
- Hiring gets easier to compete in.
(Competitor layoffs and reduced stock option values in bigger corporations mean the opportunity cost of quitting to join a startup you’ve had your eye on for some time is lower.) In addition, the most talented entrepreneurs and companies enjoy competing to secure new capital rounds in an environment where investors get much more selective.
There are secular factors to bear in mind as a driver of venture capital investments, over and above the capital market cycle. Accel Founder Arthur Patterson, whose lifetime of venture experience spans multiple market cycles, shared with me the observation that the supply of innovative new companies is the real determinant of overall longer-term returns, created primarily by technological innovation but with social behavior trends also a factor in enabling new company supply.
These secular factors in the formation of new companies are independent of VCs or IPOs. Consider how the year 2008 was not only the lowest point in the business cycle but also a pivotal year in the development of mobile (iPhone 2 released ex-US and with 3G) and cloud computing technologies (DropBox first software release, 2008, with iPhone app 2009). Facebook and Twitter would not have gone viral in the same way in the early 2000s on desktop web browsers as they did on smartphones from 2008-10.
Mar Hershenson, Managing Partner, Pear Venture Capital provides a view of the future.
“We will see more real companies and better investors. Less money in the system means companies need to have better operational excellence (do more with less money). Investors are also going back to basics. Diligence is back, along with appreciation for companies that are building real value, not relying only on future value. Less founders. Less investors. More opportunities. When it is harder, the tourists leave.”
Startups are going to have a tough year in 2023. While many have gotten their burn rates way down, most startups still are losing money and will eventually need to raise capital in 2023. Because most startups avoided raising in 2022, there will be a glut of startup companies in the market for capital this year and while there is plenty of venture capital sitting on the sidelines waiting to be deployed, VCs will be much more selective, instead of funding everything that moves as we’ve done over the last few years.
Good businesses with product market fit, positive unit economics, and strong leadership teams will raise capital although it will be at the new normal in terms of valuation. I believe that “new normal” is more or less where we were in 2015:
- Seed rounds were done around $10mm.
- A rounds were done around $15mm to $25mm.
- B rounds were done around $25mm to $50mm.
- Growth rounds had a cap at 10x revenues.
This new normal will lead to many:
- Flat Rounds - A flat round cis when the valuation remains the same from the previous round of funding.
- Down Rounds - A down round refers to a scenario where the value of a business at a time of investment is below the value of the same business during a previous period or financing round. Normally during a down round, investors purchase equity in the business at a lower price, in comparison to previous investors.
- Inside Rounds - An inside round is additional investment that is made by a company's existing investors. From outside a company, it is difficult to know why it was done or whether a company is doing well or not.
- Structured Rounds - Highly structured rounds are almost debt that sits on top of the existing equity capitalization structure.
None of that is good, but the worst of those options is rounds with a lot of structure. I believe founders and CEO's and Boards should take the pain of a new valuation (flat, down, whatever) over structure.
But there is a huge number of startups out there that have not really found product market fit, have not created positive unit economics, and have unresolved issues in their founding teams and leadership teams. These startups will struggle to raise capital at any price and most of them will fail. This has already started to happen but because so much capital was raised in 2021 and the early part of 2022, it has taken longer for these companies to fail. I think we will see a lot of startups in this category go under or taken out in fire sales in the first half of 2023.
Venture Capital Slowdown Is In Full Swing
Global venture funding reached $74.5B in Q3’22, hitting a 9-quarter low. This represented a 34% drop quarter-over-quarter (QoQ) — the largest quarterly percentage drop in a decade — and a 58% decline from the investment peak reached in Q4’21.
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The number of deals fell to 7,936 total, marking a 10% quarterly drop.
US-based companies accounted for just under half (49%) of global funding in Q3’22, collectively raising $36.7B across 2,866 deals. Some of the largest rounds in the US went to TerraPower, EnergyX, and Xpansiv.
As noted previously, VC firms have huge amounts of a capital available for startups, but are adopting the "new normal" when deciding on seed to late stage rounds, and limiting funding in 2023 to startups with my "Big Four Must Haves":
- Proven Market Fit.
- Sustainable Business Model.
- Experienced Management Team.
- Competitive Advantages.
As a management consultant, I strongly recommend that startup CEO's and founders concentrate on innovation, indentifying their best customers, understanding the customer journey start-to-finish, rapid and precise execution to gain traction and market share and developing competitive advantages. This is why an experienced management team is so important and essential in executing the "Big Four Must Haves."
Deal Count and Value Declines in Q3 and Q4 2022
The deal count in 2022 for the full year was 15,852, down 14% from 18,521 in 2021. And deal value was $238.3 billion, down 30% from $344.7 billion a year earlier, according to a report by Pitchbook and the National Venture Capital Association (NVCA).
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U.S. VC exit activity was 1,208 deals valued at $71.4 billion, down dramatically from 1,925 deals valued at $753.2 billion a year earlier
Acquisition activity has also declined significantly; Q4 posted roughly $763 million in total acquisition deal value, the first time we have seen this quarterly total fall below $1 billion in more than a decade.
How Many Startups Fail?
Approximately nine startups out of ten fail. 20% of the startups fail to complete even one year in the market. In the following section, you will come across facts and figures related to the failure rates of startups.
- 90% of the startups fail and are shut down.
- Within the first year of establishment, 10% of startups fail.
- Companies with 11 to 50 employees are at greater risk of failure.
- 70% of startups fail within two to five years of their establishment.
The following table breakdowns the startup failure rates after various years of establishment.
| Until The End of The Year | Failure Rate |
| 1st year | 20% |
| 2nd year | 30% |
| 5th year | 50% |
| 10th year | 70% |
- Only 6% of the startups that went over Shark Tank have shut down.
- 75% of venture-backed companies rarely return the cash to the investors.
- In 30 to 40% of cases of startup failure, investors lose their initial investment.
- Only 0.05% of the startups receive VC funding.
- 43% of entrepreneurs are concerned about the failure of their startups.
- 80% of e-commerce startups fail. The rest 20% succeed significantly.
- In the USA, 80% of startups fail.
Courtesy of an article dated December 22, 2022 appearing in Forbes, an article dated January 1, 2023 appearing in AVC, an article dated October 11, 2022 appearing in CBInsights, an article dated January 5, 2023 appearing in Venture Beat and an article dated January 11, 2023 appearing in Pitchbook
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