Venture capital is a heady industry: Big bets mean big checks when the deals hit right. And for most of the last decade, those taking part in the funds were riding high: Capital was abundant, valuations were soaring, and the stock market was pumping out massive exits. This led a flood of new investors, from part-time novices to deep-pocketed hedge funds, to get into the game, pushing the sector to a record-breaking $344 billion in deals in 2021.

So when the Federal Reserve raised interest rates in spring 2022, it was akin to pulling the plug on the DJ booth. “Right now the industry is going through a massive hangover after a complete rager,” says Jo Tango (MBA 1995), a senior lecturer at HBS and a venture capitalist who has exited from three unicorns. Like any financial industry, venture capital is a cyclical business, Tango emphasizes, so the good times—and big dollar signs—couldn’t last forever. Only, when this party ended, the value of exits fell by 90 percent by the end of 2022. In his new teaching note, “Venture Capital at a Crossroads,” Tango outlines how the industry arrived at this moment and asks what the future holds for the field.

The period stretching from the late 2010s to 2021 saw a rash of seed funds, incubators, angel investors, and crowdfunding platforms all arrive on the scene, plying early stage companies with cash. Meanwhile, the massive VC firms were raising billion-dollar funds, and hedge funds saw an opportunity to get into the game. It meant that money, and lots of it, was everywhere.

But as the economy hit the skids in the spring of 2022, that optimism faltered. High inflation, spiking consumer prices, and uncertainty in the stock market caused economic malaise to set in. Within the tech sector, valuations plummeted. “Meta lost two-thirds of its valuation, Amazon lost half of its value, and Alphabet lost just over one-third of its value,” Tango writes. Those companies were forced to lay off staffers, he says. Now the ripple effect is being felt in the venture capital industry, too.

“What’s happening right now is, frankly, a lot of layoffs,” Tango notes. “These layoffs happen quietly, but they’re pretty rampant. And it’s not just the new unknown firms. The major firms also have cut heads.” The reason, according to Tango, is simple math: VC firms have to deploy the capital they raise in a fund within a five-year investment period. Right now, some of those mega-funds raised in the boom times are feeling bloated, and limited partners have been stepping in and asking to cut the size of funds and release them from legal commitments. Because VC firms make money by collecting fees from their funds, those trims stand to cut into senior partners’ profits, he says.

“A lot of people don’t want to take pay cuts. So they shrink their cost structure and lay off junior investors or unproductive senior investors,” Tango explains. “That’s the inside baseball that few people know about.”

There’s been a slowdown elsewhere within the industry, too. Last year’s decline in IPO activity meant VC firms generated just $71.4 billion in exits compared to $753.2 billion in 2021—a 90.5 percent drop. Fundraising also plummeted. Only 769 funds raised money in 2022, down from 1,270 the year before.

Now people still in the game are dealing with the ripple effects. “Deal flow has really slowed down,” says Kerry Rupp (MBA 1999). Rupp has seen as much at her Austin, Texas-based firm True Wealth Ventures, where she’s a general partner of an early stage fund investing in women-led businesses.

Rupp’s approach is more moderate than that used by some of her Silicon Valley brethren, so in some ways she’s not feeling the hangover effects as much as the bigger firms. “I wouldn’t say we were at that rager, but I would say we saw the rager happening around us,” she jokes. The slowdown in deal flow is felt by everyone now.

“Almost all of our companies have needed more runway,” Rupp says. “Partly that’s because they haven’t had the progress they need to because of the economic environment in which they’re sitting. And then also because the VCs at the next stage are not writing the big checks that often.” Rupp has spent the bulk of the last year helping the 17 companies she backs navigate bridge rounds. That has meant she spends less time pursuing new deals. “This is totally the new normal right now,” she acknowledges.

Tango argues that this reset could be an opportunity, too. He says that VC firms have long been grappling with demands within the industry to diversify and incorporate more ESG considerations into their investment frameworks, and many have now taken steps to better assess and address their shortcomings.

Rupp agrees and hopes that this moment might be a right-sizing of sorts. The biggest players in the VC game, she says, have always tended to flow scads of money to the biggest talkers (WeWork founder Adam Neumann got a multimillion-dollar deal last year for his new startup, Flow, she notes, having blown billions.) But as the industry slows, it could be an opportunity to reassess the way they do business.

“We are very data-driven, and all the data shows that diversity in teams can actually lead to out-performance,” Rupp observes. Her firm’s mission is to have its values align with the economic opportunity, and she notes all the companies she funded held on during the pandemic in part because of that level-headed mentality. “I know there are people who feel like the ESG stuff is a distraction,” she says. “We think those things are fundamental.”

Tango believes trends are promising, though he does remain a bit skeptical about if, and how, any real changes will manifest when the industry picks back up. In the meantime, he says, those in the sector will have to ride out the current hangover, perhaps with some Advil in hand. “Things are never as good as we think they are. They’re never as bad as we think they are. But I’m very optimistic for the VC industry,” Tango concludes. “It’s very resilient, and it’s being right-sized. But it’s not going to go away.”
By: Janelle Nanos

Illustration by Adam McCauley