As VCs turn conservative, innovation must still be funded 

THERE is little doubt that it is already happening. The free money days of 2021 are pretty much over for now. According to data compiled by Crunchbase, global venture funding in 2022 totalled US$445 billion – lower by 35 per cent compared to the previous year.

Venture capital (VC) firms are cautious as the cost of capital goes up and investors have less allocation for private equity and venture capital. So, VCs are focusing on keeping their portfolio companies afloat.

These are tough times, and many startups are finding it a struggle to raise the capital to grow and are cutting costs. Some might say it was a bubble waiting to burst; the relentless chase for growth which led to an unrealistic valuation of companies was not sustainable and made little business sense. Unfortunately, funding winters are a natural part of the VC funding cycle that, in fact, help to keep companies more or less on the right track over time.

Innovation gets hit

During a funding winter, innovation is significantly impacted. Funded startups often reduce their research and development efforts, while unfunded ones struggle to bring their products to market. This has long-term implications for global economic growth if the funding drought persists. Contrary to the belief that good companies will always secure funding, investors tend to flock to startups with notable investors, which does not necessarily indicate their quality. As a result, some exceptional ideas are put on hold, and the funding winter trims not only excess ventures, but also hampers the progress of promising initiatives.

The consequences of a funding shortage extend beyond individual startups, affecting the broader economy. Stagnated innovation impedes technological advancements, job creation and overall economic growth. Without sufficient funding and support, transformative innovations remain unrealised, depriving society of their potential benefits. However, it is important to recognise that a funding winter is a temporary phase, presenting opportunities for resilience and strategic thinking. By persevering, adapting strategies and exploring alternative funding avenues such as government grants and partnerships, startups and investors can emerge stronger and continue driving economic growth when investment activity rebounds.

Risk mitigation during lean times 

During lean economic periods, risk mitigation becomes crucial for VCs. They must carefully select companies to invest in, focusing on those that demonstrate a lower burn rate and a clear path to achieving the next valuation milestone or profitability. Collaborating with other investors in a syndicate can be advantageous, as it increases the funding base and diversifies risk.

In particular, including strategic investors can be beneficial because they often possess substantial financial resources and can lend credibility to young and emerging companies. Furthermore, VCs may consider reducing the number of companies in their portfolio, prioritising those with the most promising prospects. This strategic approach helps conserve financial resources, known as dry powder, which can then be allocated to support and nurture the growth of the most promising companies in the portfolio. By employing these risk mitigation strategies, VCs can navigate lean times more effectively, maximise their returns and enhance the overall success of their investment portfolio.

Moreover, during lean economic periods, VCs may adopt a more hands-on approach to managing their investments. They may provide additional guidance and support to portfolio companies, leveraging their expertise and network to help navigate challenging market conditions. This active involvement can range from strategic advice on product development and market expansion, to operational assistance in optimising cost structures and improving operational efficiency. By actively engaging with their portfolio companies, VCs can increase the likelihood of success and mitigate potential risks associated with market downturns. This collaborative and proactive approach not only strengthens the relationship between VCs and entrepreneurs, but also enhances the overall performance and resilience of the investment portfolio.

Startups navigating through the funding winter

One of the reasons that great companies do not always get funded is that they may not have all the right ingredients that investors are looking for at a particular time. Investors typically look for companies with a strong team, a product or service that addresses a significant market need, and a clear business plan that outlines a path to revenue and profit generation. These are well-known and perennial. In light of what VCs look for in such times, companies will do well to lower their burn, focus on shorter infection points, get as many known names on their capitalisation table as possible and lower valuation expectations.

Many investors have also become more mindful of ESG considerations in their investment decisions. Although this emphasis has decreased in the higher interest rate environment, it still remains an important focus for many. Startups that prioritise sustainability, social responsibility and ethical practices are likely to get another tick of a box.

The cycle of booms and busts occurs in all sectors of the global economy. The key takeaway from past cycles is that counter-cyclical investments make the best returns. So investors would do well to be investing during a funding winter than at any other time.

The writer is founder and chairman of Vickers Venture Partners