How do startup failures impact the overall venture capital market?

Venture capital is an extremely challenging market as more than two-thirds of all startups never provide a positive return to investors. However, startups also offer returns that no other asset class could possibly provide. Hence, accredited investors are willing to take this risk. The reward matches the risk.

However, even accredited investors would not want to risk losing their entire portfolio.

Hence, a shift in startup failure rates can change how venture capitalists make investment decisions. In this article, we shall see how these changes can reshape the venture capital market.

How do rising startup failure rates impact the venture capital market?

Here, we shall explain how startup failure rates impact the venture capital market by discussing the most likely outcomes of rising failure rates.

Falling valuations

When failure rates rise at startups, venture capitalists must acknowledge that startups are now riskier investment avenues than previously thought. As a result, investors would ask for a higher risk premium, which increases the discount rates. Higher discount rates would naturally reduce valuations. Until a reversal in startup failure rates, these high discount rates would persist.

Let us understand this with an example. Suppose that Giga Machino, a robotics startup, is expected to earn $1 million in free cash flow every year and, given its status as an early-stage startup, it can only be reasonably expected to stay in business for 5 years. At the end of this period, the startup is expected to have a terminal value of $3 million. Let us see how its value changes with high discount rates.

Thus, higher discount rates effectively reduced Giga Machino’s valuation by about 25%.

Fewer funding rounds

In order to avoid a down round, startups with a manageable burn rate may postpone fundraising. Some startups may even turn to venture debt to extend their runway for the very same reason and for the added benefit of not diluting their equity. Another form of funding startups could explore includes revenue-based financing. In fact, Lighter Capital, a prominent player in revenue-based financing, was founded in 2010 when raising funds became notoriously difficult for startups.

On the other hand, venture capitalists themselves would be hesitant to fund new startups. Until the key cause of the spike in startup failure rate is identified and addressed, VCs are likely to introspect and reconsider their shortlisting criteria. A consequence of this could be more stringent due diligence processes, which would lead to prolonged funding rounds.

Preference for late-stage startups

A likely consequence of stringent due diligence processes is late-stage startups being preferred over early-stage startups. A late-stage startup is more likely to have an established business model, market presence, and proven product-market fit. In contrast, early-stage startups are riskier and lack substantial market validation. As investors conduct deeper financial, operational, and legal evaluations, they may prefer funding companies with demonstrated traction rather than those in the ideation or product-market-fit phase.

Hike in interest rates

With startups flocking towards venture debt lenders, the lenders themselves are likely to increase their interest rates. They must and can do this for two reasons. Firstly, when the demand for a product rises, the producers, which would be the lenders in this scenario, would have greater price setting ability. Additionally, venture debt lenders must increase their interest rate because, in a way, they too are investing in a startup and if an asset becomes riskier, it must provide a better return.

Eqvista- Deciphering trends, unlocking value!

If a promising startup wants to avoid becoming collateral damage when venture capitalists are alarmed by the rising startup failure rates, it must exercise financial discipline and display commercial viability. Having such objectives not only boost the chances of survival in a challenging market but also ensures high valuations in favorable markets.

At Eqvista, we offer credible, data-backed and detailed valuations which can bolster your valuation and improve the chances of fundraising success. Contact us to learn more about our services!