Wharton@Work

May 2023 | Finance

Venture Capital: Expertly Navigating Today’s Uncertainty

“Our money is gone.” They’re not the words anyone wants to hear from a venture firm they’ve invested in. But that’s what Wharton finance professor Kevin Kaiser was told after the failure of Silicon Valley Bank [SVB], the preferred institution for many Silicon Valley venture-financed companies and venture capitalists. Hours later, though, they called back, assuring him that the money was still there. In a matter of hours, Kaiser got a real-world sample of one of his classroom lessons: venture capital is currently facing massive uncertainty.

“No one seems to have a good handle on what's going to happen next,” says Kaiser, who is senior director of Wharton’s Harris Family Alternative Investments Program. “These are very uncertain times, and so much depends upon what the Federal Reserve does and what the Treasury and FDIC do. A lot of people are expecting a recession, but at the same time, nobody really knows. When SVB failed, the government and the FDIC stepped in and guaranteed all deposits, setting up immediate liquidity provision so banks have access to liquidity in the event that there's a run. But then the Treasury said they will not continue to grant unlimited insurance on deposits. They did it for Signature and SVB, but they won't do it for other banks. That kind of arbitrary move only raises uncertainty higher.”

Kaiser says there’s even greater confusion because at the same time the Federal Reserve is accelerating the economy with liquidity, it’s putting the brakes on by raising interest rates. “Again, nobody knows how that's going to work. It's confusing. And venture capital is one of the areas that is most sensitive to all of those factors because you’re investing now in something that's not going to pay off for many years.”

“Most investments start paying off within a couple months, or a year or two,” he continues. “If we're in a big company that does long-term investments like pharmaceuticals or oil and gas or chemicals, the economy doesn't disappear based on what the Fed does. But for venture capital and banks, it does. It matters.”

The Short-Term Outlook: Skills Needed

What can venture capitalists and investors expect in the short term? Kaiser says raising money is likely to become much more difficult, “which means prices and valuations are going to go down. That's going to put a lot of pressure on both the venture capitalist firms and the portfolio companies who need the money and are going to have trouble getting it because their ‘valuations’ have gone down.”

That pressure leads to an even greater need for due diligence. “When everything was going up for years, skills weren't all that relevant,” says Kaiser. “Now, given the uncertainty, you really need a good skill set to understand the companies you're putting your money into and to have some confidence that they have the ability to pay you back. As Warren Buffet famously said, ‘Only when the tide goes out do you learn who has been swimming naked.’ The tide hasn’t gone out for a long time, but now we’re about to find out who those naked swimmers are.”

Today’s increased risk means the terms under which you invest are more important than ever, Kaiser says. “If you don't protect yourself with them, you can end up more exposed now than ever before.” It is those skills that form the core of the Venture Capital program in which he teaches. Participants learn how to better understand valuations and term sheets, and how to diagnose and evaluate entrepreneurs.

Kaiser’s session on term sheets, for example, explains how to recognize the terms that go into investment agreements. “There are covenants that can protect you and protect your investment more effectively,” he says. “Those terms include things like liquidity preference, influence over board decisions, oversight and influence over cash consumption, the ability to replace the founders, and perhaps anti-dilution terms to mitigate your value loss in a down round. These and other terms were not as important in the past, but now that we can expect down rounds, and financial distress, they have become critical.”

What’s Next

Kaiser says some venture capital funds were starting to suffer even before the current crisis. “I had a call about three months ago with a firm that’s having a difficult time raising money for their next fund. Now, I expect more and more VCs to have the same difficulty,” he says, “especially if they aren't getting one or two good exits from the first fund. People aren't going to invest in the second fund, and so they're going to have to close. There's going to be a reasonable number of VC funds that popped up in the past 10 years that won’t be able to continue.”

To avoid that fate, venture capitalists should make the investment in skill development. “When things are going well and they feel flush with cash,” says Kaiser, “they come to our program because they have money to spend. When things are going badly — when they really need the skills — they don't feel flush, so they don't tend to want to spend money. But when times are tough, the skills become more relevant and more necessary. When times are good, even if you're incompetent, you can still make money in many cases. Now that times are expected to become more lean, more tough, and more tricky, though, you want to make sure you have your skills.”