VCs Face an Existential Threat: There Are Too Many of Them

In the 2010s, back when you could toss a dollar bill into the wind and earn a 20% return on it, it felt like anyone with a bit of money and a lot of confidence was suddenly working at a venture capital firm. As Jeff Clavier, a longtime venture capitalist, put it to me: “Everybody became a VC because it was fun, because it was up and to the right, because it seemed easy.” 

A growing cadre of VCs, some very young and with little to no genuine professional experience, descended onto the scene, sometimes irking the established class. “A serial founder who's built multiple businesses in the past, like, why the hell are they taking advice from a 21-year-old?” one such VC mused to me.  Nevertheless, graduates from top colleges, after decades of walking straight off the stage and into McKinsey HQ, dreamed of life as a member of the All-In podcast. Every single former FAANG employee seemed to be an angel investor. Interest in the profession was so high that thousands of young people joined a “global collective” of angel investors and “aspiring VCs” called—what else?— “Gen Z VCs.” Even founders, typically focused on keeping their own startups afloat, created venture side projects. 

For a moment, VCs became something new: cool.

Oh, what a difference a couple of years and a few interest rate hikes can make. For new and old VCs alike, the climate bears little resemblance to the go-go days of Bored Apes and metaverse land grabs. All the AI hype in the world couldn’t stop VC funding from dropping 49% in the most recent quarter compared to just one year earlier, when the precipitous drop in VC land was already well underway, according to CrunchBase. What had very recently been a fun, easy job—taking other people’s excess cash and giving it to someone who is starting a business—has morphed into something more stressful (and occasionally existential). 

“We are in the most challenging fundraising market for VCs we have seen in years,” said Clavier.  “Being a VC in this environment is really, really hard.”

Talk to VCs today, and they’ll all say that they and their funds are doing just fine. But there is an unmistakable unease. At the center of things is the justifiable anxiety that has crept into the minds of the most important and least-discussed cogs in the startup ecosystem: the wealthy investors, pension funds, and endowments known as limited partners, or LPs, which have handed over hundreds of billions of dollars to VCs over the last decade in hopes their numbers would come up on the roulette wheel. During the boom years, this proved a great idea, and the VCs returned so much money to their LPs that economist Larry Summers went on TV and lambasted Harvard for not taking on as much risk as its Ivy League peers.

But now, as a result of going all in during the 2010s, “LPs are way over allocated to venture,” said Albert Wenger of Union Square Ventures, reflecting the thoughts of others. With interest rates up, some VCs have started to believe their money men and women will pull back and otherwise look elsewhere. “It's going to give somewhere,” said Wenger. And when it does, many VC firms will start to face the same pain that their tech startups have already endured for years as their profession downsizes to adjust to the new normal after years of stacking other people’s chips and pocketing a cut whatever the results.  “The retrenchment is happening,” said the venture capitalist Eghosa Omoigui. “It's definitely happening.”  

But there are also subtle signs the industry won’t go down without a fight, or at least procrastinating wildly in an attempt to delay the inevitable for as long as possible—and pull in as many fees as they can in the meantime.

“There's now armies of young people running around,” said Josh Lerner, a Harvard Business School professor who studies the industry.

Many players will willingly admit on the record that there are just too many of them for their own good. “If you look at the industry as a whole, it's too big,” said venture capitalist Sheel Mohnot. “The industry has to shrink.”  In 2021 and 2022 combined, venture capitalists invested more than $1 trillion in startups all around the world. Considering a decent return in the venture industry is around “3x,” or three times the investment, that means venture firms would need to return more than $3 trillion for everyone to be happy, and that’s just covering those two years.  

“I just don't see where these returns are going to come from,” said Mohnot. “Even in the best years, returns were not that high.”

When the funds miss their targets, they will face the same pressures they so often put on the startups below them. Hadley Harris, who runs Eniac Ventures in New York, said he expects more than half of all seed funds won’t make it through the current downturn. Though not many others were willing to put a number on it, the VCs I spoke with by and large agreed with the sentiment that a lot of small funds and firms would likely die out. Whispers have already begun of general partners who plan to shut down. During presentations in recent years, Frank Rotman, a prominent venture capitalist who has made Forbes’ Midas list of top VCs six times, has estimated that as many as 80% of venture firms now sit in strategically challenged positions.

In May 2022, Rotman laid out why at a New York conference, saying that top firms were hoovering up more and more of LPs’ money, which was pushing many of the remaining venture firms into a nine-step “death spiral,” which, he said, follows a consistent pattern: Lesser-tier VC firms struggle to win or even “see” the best deals, so they overpay to invest in top companies or settle for second-rate startups. After the investment underperforms, their track record takes a hit; as a result, they struggle to raise capital, then lose their top talent, then can’t adequately help the startups they’ve invested in. Their brand then suffers, and they struggle further to win good deals once more. Eventually, so the thinking goes, they spin out—and die.

Here and there, you’ll find hints that the great shrinkage is already underway—not just for startups, which are more obviously and very publicly struggling, but for the wise venture investors who are theoretically supposed to serve as a calm and level-headed presence in the world of Silicon Valley, but more realistically get swept up in the same hype as the companies they support.

Investment firms including Anthemis Group and Backstage Capital have already reduced headcount. SoftBank’s Vision Fund reportedly plans to do the same after impressively losing $7 billion in a single financial year, though Masayoshi Son’s belief in himself has been restored by conversation with ChatGPT. Y Combinator cut staff and ended a fund focused on late-stage startups. Assure, a startup focused on helping others invest in startups, completely shut down late last year. Fractal Software, a venture studio that came up with 130 of its own startup ideas and then hired people to do the actual work, decided to stop doing that and lay off staff as well (though it is still reportedly supporting already created companies). 

Considered on their own, the developments could be written off as one-off miscalculations by bit players or eccentric leaders. But there are more telling signs even among more established firms that something broader is amiss. The news last month that the well-regarded venture firm TCV had raised as much as 75% less for its primary fund than the $5.5 billion it had hoped for took VCs of all sorts aback. So did Insight Partners’ decision to reduce the amount it hoped to raise for a new fund by $5 billion due to the slow pace of fundraising, which it announced alongside a message that it believed the industry was witnessing a "great reset.” 

“That is, I think, a sign of what's to come, which is: it's going to be hard,” said Mohnot. Others agree. “I don't think we've seen the worst of it yet—by a wide margin,” added Wenger of Union Square Ventures. “It'll be hard to say how much it'll shrink, but it'll shrink for sure.” The biggest brands in the business—think Sequoia Capital—will likely be fine due to long-term relationships with their LPs, but the hundreds of other smaller VC firms are left to fight for the scraps or even facetime. “For many funds, it is harder to establish new LP relationships,” said Dan Abelon, a VC at Two Sigma Ventures. 

One venture capitalist who decided to become a limited partner in a number of funds outside of his own during the boom years told me that he is now pulling back everywhere except his own fund.

“I’m going to renew none of them,” he said. “We're not IPOing companies like we were, so I don't have liquidity.”

The issues are not limited to the little guys. Some funds that focus on large startups, known as later-stage startups, have hit a wall as fewer companies IPO, meaning there are few ways to “exit,” a coy term that means get a bunch of liquid money back. “That's leading to a lot of tensions among organizations,” said one VC to me. Tiger Global Management, which not too long ago had roared to the top of the venture market by investing—even by VC standards—an astonishing amount of cash, has reportedly been trying to sell off its VC investments on the secondary market after one of its figureheads, John Curtis, left the firm last year after his massive failed bet on tech at the exact worst time. 

Whereas the startups themselves are already multiple years into cuts and downsizing, change in the venture industry is slower. “Venture firms are very sticky,” said Lerner, the Harvard Business School professor who studies the industry. The lifecycle of a typical VC fund is around a decade, and venture capitalists  get paid according to a two and 20 model, meaning they charge a 2% fee for the assets under management while also earning 20% of profits in a lot of cases. If it’s hard to fundraise anyway, or the fund is on pace to underperform and die out, a venture capitalist might as well slow down the business and charge the 2% annual fee a year or two longer. The strategy is particularly beneficial to “large funds that have large management fees,” said Wenger. According to PitchBook, the number of deals has been dropping precipitously since the end of 2021. That could be partially explained by the fact that VCs are focusing all their efforts on helping already well-funded startups survive, but it’s not the only reason either. 

Said one VC who, obviously, didn’t want his name associated with the quote: “As long as the fund is active, someone is paying your salaries.”

Venture firms that were lucky enough to raise money right before the bottom fell out of the tech industry might not have a chance of survival, but because they’d need to raise again for some time, they can mask their future failure. The New York-based VC (and podcaster) Logan Bartlett referred to this group of venture firms as “dead, but still walking.” (Bartlett puts his firm in the “pragmatic and disciplined” bucket of investors, obviously.)

All the doom and gloom is leading to making fewer big, wild bets, which, theoretically, is the entire point of the enterprise. “VCs, in general, are becoming more risk averse,” said Abelon, the VC at Two Sigma Ventures. “There is less interest in investing in non-consensus or out-of-favor areas.”  

Instead, at least according to some of the VC themselves, a good amount of the “dry powder”—or uninvested money—is helping to mask how much less valuable the VC’s collections of startups have become. The valuations of private tech companies have not fallen as much as those on the public markets, and numerous VCs said a primary reason is that admitting a startup has become less valuable would make the VCs look bad and have a harder time raising money from LPs in the future—creating “perverse incentives” for some firms, as Bartlett put it, for firms to keep valuations of their startups as high as possible. Wenger said VC’s desire to look good to LPs was in fact “the number one reason” why private startup valuations have remained so disproportionately high, which the VCs themselves know is concerning, even if they collectively have not done much to fix it. 

“This artificial behavior, I think it's very worrisome,” said TX Zhuo, a Los Angeles-based venture capitalist. “We're still artificially propping up the valuation of all these companies that should see a correction in valuation.”

The discrepancy can only be so well-masked. Shares of startups are now trading on the secondary market for 61% less on average than they were supposedly worth in their latest funding rounds, according to one recent report by a firm that tracks the private market. 

More cuts are likely coming, especially for young support staff, and a number of venture capitalists suspect that the downturn will be hardest on women and minorities, who were beginning to make some inroads, however minimal, in the historically white- and male-dominated sector. Instead, the sector could revert, becoming even whiter, older, maler, which will affect which ideas receive funding—and which do not. 

“This system has a lot of lags built into it. So it's going to take quite a bit of time to work its way through,” said Wenger. But, he said, the VC slowdown has clearly started, and it’s not close to over either. “The big reckoning will come when all that money runs out.”