The rise of zombie VCs is haunting tech buyers as startup valuations plummet
An art exhibition based on the hit TV series The Walking Dead in London, England.
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For some venture capitalists, we’re approaching a night of the living dead.
Startup investors are increasingly warning of an apocalyptic scenario in the VC world – namely the emergence of “zombie” VC firms struggling to raise their next fund.
Against a backdrop of higher interest rates and fears of an impending recession, VCs expect hundreds of companies to attain zombie status over the next few years.
“We expect there will be an increasing number of zombie VCs; VCs that still exist because they need to manage the investments they made from their previous fund but are unable to raise their next fund,” Maelle Gavet, CEO of global entrepreneur network Techstars, told CNBC.
“That number could reach up to 50% of VCs over the next few years who simply won’t be able to raise their next fund,” she added.
In the corporate world, a zombie is not a dead person who comes back to life. Rather, it’s a company that, while still making money, has so much debt that it can barely pay off its fixed costs and interest on debt, not the debt itself.
Life for zombie companies becomes more difficult in a higher interest rate environment as it increases their borrowing costs. The Federal Reserve, the European Central Bank and the Bank of England all hiked rates again earlier this month.
In the VC market, a zombie is an investment firm that is no longer raising money to back new ventures. They still work in the sense that they manage a portfolio of investments. But they stop writing new checks to founders as they struggle to make returns.
Investors expect this bleak economic backdrop to create a horde of zombie funds that are no longer generating returns and are instead focused on managing their existing portfolios — while preparing to eventually wind down.
“There are definitely zombie VC firms out there. It happens in every downturn,” Michael Jackson, a Paris-based VC who invests in both startups and venture funds, told CNBC.
“The fundraising climate for VCs has cooled significantly, leaving many companies unable to raise their next fund.”
VCs take funds from institutional backers known as LPs, or limited partners, and give small amounts of the money to startups in exchange for equity. These LPs are typically pension funds, endowments, and family offices.
If all goes well and that startup successfully goes public or is acquired, a VC will get the funds back or, even better, make a profit on their investment. But in the current environment, with startup valuations being slashed, LPs are getting pickier about where to park their money.
Because the companies they back are privately held, any profits VCs make from their bets are paper profits — meaning they are not realized until a portfolio company goes public or is sold to another company. The IPO window has largely closed as several technology companies choose to suspend their listings until market conditions improve.
“We’re going to see a lot more zombie venture capital firms this year,” Steve Saraccino, founder of VC firm Activant Capital, told CNBC.
A sharp drop in technology valuations has taken its toll on the VC industry. Publicly traded technology stocks have stumbled in high-growth areas of the market amid deteriorating investor sentiment Nasdaq down almost 26% from its peak in November 2021.
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A chart showing the performance of the Nasdaq Composite since November 1, 2021.
As private valuations catch up to equities, venture-funded startups are also feeling the cold.
Stripe, the online payments giant, has seen its market value plummet 40% to $63 billion since it peaked at $95 billion in March 2021. Buy now, pay later, lender Klarna, meanwhile, most recently raised funds with a valuation of $6.7 billion, a whopping 85% off the previous fundraiser.
Crypto has been the most extreme example of reversal in technology. In November, crypto exchange FTX filed for bankruptcy in a stunning flameout for a company once valued at $32 billion by its private backers.
Investors in FTX have included some of the most notable names in VC and private equity, including Sequoia Capital, Tiger Global and SoftBankwhich raises questions about the level of due diligence — or lack thereof — that goes into deal negotiations.
A flood of new venture funds has emerged over the past two to three years as a result of persistently low interest rates. According to figures from data platform Dealroom, a total of 274 funds were raised by VCs in 2022, more than in any previous year and a 73% increase from 158 in 2019.
– WANT TO FIND SOME DATA FROM DEALROOM FOR THIS FOR A CHART –
LPs may be less inclined to lend money to newly formed funds with less experience than names with strong track records.
“LPs are pulling out after being overexposed to private markets, leaving less capital to bypass the large number of VC firms that have formed in recent years,” Saraccino said.
“Many of these new VC firms have not proven themselves and have not been able to return capital to their LPs, meaning they will have great difficulty raising new funds.”
Frank Demmler, who teaches entrepreneurship at Carnegie Mellon University’s Tepper School of Business, said it would likely be three to four years before struggling VC firms show any signs of distress.
“The behavior won’t be as obvious” as it is with zombie firms in other industries, he said, “but the telltale signs are that they haven’t made any big investments in the last three or four years, they have not raised a new fund.”
“There have been many first-time funds funded over the buoyant past few years,” Demmler said.
“These funds will probably get caught halfway through where they haven’t had an opportunity to have too much liquidity and have only been on the investment side of things if they were invented in 2019, 2020.”
“They then have a situation where their ability to generate the kind of returns that LPs want is almost nil. That’s when the zombie dynamic really comes into play.”
According to industry insiders, VCs won’t be laying off their employees in droves, unlike tech companies, which have laid off thousands. Instead, they will lose staff over time to attrition and avoid filling vacancies left by partner departures as they prepare to eventually wind down.
“Winding up ventures is not like winding up a company,” said Hussein Kanji, a partner at Hoxton Ventures. “It takes 10 to 12 years for the funds to close. So basically they don’t charge any management fees and the management fees go down.”
“People leave and you end up with an emergency crew that manages the portfolio until it’s all sold out within the decade allowed. That happened in 2001.”