Will 2016 Bring a Venture Capital Drought?

February 21, 2016

We would like to thank our sponsor, EY, for providing The Montgomery Summit with this piece on venture capital firms.

By Jeff Grabow, EY’s US Venture Capital Leader

There is one question that’s been on market watchers’ minds for months: are we in a bubble? Everyone has an opinion, but the common thread is that funding increases can’t continue forever. Funding will slow sooner rather than later. Today’s prudent entrepreneurs must make sure they have more than enough capital to reach their next milestone. This will help them manage risk and could help them secure the long-term success of their company.

In California, weather forecasters insist that El Niño will alleviate our current drought conditions. The opposite situation has been happening in venture capital, where money has been flowing freely into investees for the past two years. Today, venture capital pros are contending that a shift in venture financing is underway that will slow the pace of investment and lead to a capital drought for VC-backed companies.

2015 saw the amount of venture capital invested increase over 2014, but the final quarter showed a definite slowdown in both dollars and deals. In California, which garners the bulk of VC investments, the quarter resulted in the fewest deals since 2010. Down the road, cash will get tighter. When that happens, the funding terms for capital that is available may not be as attractive as they have been in the past. And keep in mind that when there is a funding pullback, entrepreneurs raising money are competing against the pool of all companies that need capital — not just against companies selling similar products or services — which will only add to the pressure on companies trying to secure funding.

What’s an entrepreneur to do? In today’s environment, the balance between an adequate funding level and an appropriate valuation can be delicate. With valuations moving consistently upward, entrepreneurs need to make sure they don’t set themselves up for valuation traps. How? By making sure their company valuations are sustainable for future fund raises. It’s counterintuitive, but top-dollar valuations have haunted many entrepreneurs when they look for follow-on capital infusions.

Entrepreneurs who are concerned about dilution and want to put off raising their next rounds should remember that cash is what keeps companies alive — especially those that are not yet profitable. An important rule of venture capital is to raise money when it is available, not when it’s needed. Raising cash only when it’s needed ignores the ebb and flow of the capital markets.

If your company is in need of cash and you’re finding it difficult to raise funds, decisive action needs to be taken quickly. Cut your burn rate. This may involve layoffs, downsizing your office space and focusing your spending. A key to actions in these times is to make sure you cut enough. It will be painful, but necessary. You only want to go through it once, so make sure you get it right. If you don’t and you have to go through the process again, it could threaten the existence of the company.

Have cash to last at the current burn rate? Then don’t stop there. Consider the strategic moves needed if the economic landscape changes and it’s not in your favor, such as slowing down your hiring and limiting or scaling back new initiatives or other strategic spend to get through the lean times while focusing on a path to profitability.

All indications are that there will be a slowdown in venture capital investment. If entrepreneurs hope to thrive in spite of changing market conditions, now is the best time to prepare for the coming hot, dry summer.

To learn more about how EY advises, guides and recognizes high-growth companies & entrepreneurs, please visit www.ey.com/sgm and follow us at @EY_Growth.