Playing with Fire: Dry Powder Signals a Burning Dilemma for Startups

It’s been three quarters since the stock market bottom, seventeen months since the invasion of Ukraine, and nearly a year since CPI reached a 40-year peak. The regional banking crisis that sent shockwaves throughout the country seems largely forgotten. What was once a period of fear and uncertainty is now shaping up to a promise of a soft landing: inflation is easing, tech stocks have sparked a market rally, and consumer spending remains robust.

Granted, not all economic signs are rosy: household savings are rapidly depleting, job growth has waned, and China’s reopening has been slower than expected. However, Americans are optimistic about the economic outlook. And in this unique business cycle defined by unusual labor market characteristics, there is hope that the US economy could escape a recession.

But does that same sentiment translate to venture capital? I have previously written about the market downturn and its impact on the startup ecosystem, which typically lags the public markets by two quarters. Founders are taking steps to extend run-rate, cut burn, and prioritize unit economics - the ‘growth at all costs’ mantra no longer applies. On the other hand, investors have slowed their pace, with global venture funding falling dramatically across regions.

In times of uncertainty or downturn, the key to winning is survival. But is surviving the same as succeeding? And what does it mean for venture capital moving forward?

Several factors drive complex, intertwined markets. But part of the answer can be found in an often overlooked metric: dry powder.

Defining Dry Powder

A typical venture fund spans 7-10 years, so not all capital is deployed simultaneously. Dry powder refers to the amount of money a fund has available to invest, which measures the capacity to back new startups or support existing portfolio companies through follow-on rounds. It’s an indicator of credibility - a firm with a large amount of available capital shows entrepreneurs that it has the necessary resources to support their ventures.

During economic growth, capital is cheap, companies are marked at higher valuations, and fund returns look increasingly attractive. Limited partners (LPs) desire more exposure to startups and growth companies, making fundraising more accessible for founders and general partners (GPs).

This dynamic has caused dry powder to explode in recent years.

As the chart shows, funds are sitting on nearly $300b, more than twice the average amount seen pre-COVID and almost four times the amount that existed post-global financial crisis. In other words, dry powder is at record levels, with overhang dating back to 2015. It makes you think - is there a correlation between the amount of dry powder and the current economic picture?

Dry Powder in a Downturn

‍Recessions impact companies differently, depending on the industry or business model. Higher rates reduce the present value of future cash flows, resulting in lower valuations for growth companies, which are often valued based on their future earnings potential rather than current profitability. On top of that, fundraising activity shrinks, exit opportunities dry up, and selling a product or service becomes more challenging as customers cut their spending.

Early-stage startups must face these challenges while operating in often saturated, cutthroat markets. Fortunately, they have one weapon in their arsenal: cash.

One form of cash is the amount on a startup’s balance sheet - it determines runway, or how long cash flow-negative startups can continue operating. Dividing the cash in the bank by the monthly burn rate shows how much time a startup has until it needs to raise money again. The second is dry powder, allowing startups to tap into additional pools of capital to prevent shutting down. Depending on the success of the round, startups can buy time to pivot strategy, acquire customers, and improve margins.

This is why dry powder is critical - the more available capital exists, the greater the buffer startups should have from failing. Investors can double down on their portfolio companies or invest in new companies and verticals.

Another benefit of this metric is that it helps define the quarterly rate at which funds invest their capital - called “burn.” A venture firm typically deploys the money over four years when it raises a new fund. It’s not a cardinal rule, but the industry invests at a fairly predictable rate, generally allocating 6-7% of dry powder every quarter. All else being equal, the higher the amount of money raised, the higher the deal velocity. VC is a long-term competition defined solely by returns - every firm is in the race to finish in the top quartile and cannot afford to sit on the sidelines. Money needs to be put to work, regardless of its scarcity.

But therein lies the contradiction - if the record dry powder is a leading indicator of funding activity, why has deal activity fallen off a cliff?

One may point to the strong fundraising activity before or despite the market downturn. US-based venture funds raised over $163b in 2022 and $155b in 2021, nearly double the average in years prior (Statista). Investors may be waiting for valuations to reset or the market to bottom out before pricing terms, which explains the decline in deals.

Others can attribute it to the rise of angel & crowdfunding platforms - Pitchbook data shows that through Q3 2022, the total value of venture deals with participation from nontraditional investors hit $145.1 billion, or about 74% of all deals. This money, which is not captured in dry powder figures, has augmented the capital available to startups and allowed the growth of the asset class despite the lack of VC activity.

I think it goes beyond this.

Digging Deeper

As a fund manager, it’s easy to look at the chart above and assume, “There’s nearly $300b of capital available in the U.S. venture capital market! My portfolio companies should have no issues raising money and living through the downturn!” This attitude is widespread, as covered by various media outlets:

• Record VC ‘Dry Powder’ Could Go to AI

• Venture Firms’ Dry Powder is About to Revive Startup Finding

• VC Sitting on Billions in Dry Powder: Will This Lead to a Wave of Investment?

Unfortunately, dry powder alone cannot accurately indicate if markets are well-capitalized. A more accurate gauge is the amount of dry powder relative to the money active startups need to raise to fund operations. Given these are private companies with little public information, the latter is quite challenging to calculate – it’s a function of all U.S. startups' cash burn and runway. However, we can use the total venture investment amount each year as a proxy - this can be referred to as the Dry Powder Ratio (DPR).

Dry Powder Ratio = Nominal Dry Powder / Total Annual U.S. VC Investment

I did not coin this ratio, nor do I take credit for it - a venture fund previously performed this exercise. But it’s useful because it shows the number of years that capital reserves can be sustained, given the current investment rate. Nominal dry powder displays the total amount of money venture capitalists need to invest, while the DPR predicts the speed at which that money will be spent. A high ratio signals a surplus of capital in the ecosystem. However, when the ratio is low, venture funds must seek additional funding to support new and existing investments.

There isn't a specific ratio that should be met - it simply provides insight into our current position compared to previous years. And as the chart above shows, the amount of dry powder relative to annual deal value has fallen dramatically in the last 15 years.

It’s important to note that these figures are measured in aggregate. Each venture fund has dry powder individually, and its flexibility depends on the amount of capital raised and the companies it has chosen to back. Regardless, this trend is a warning sign for the entire ecosystem. If startups' capital needs remain constant, the $300b surplus of dry powder will last less than a year (0.9x). In other words, venture firms rely more on new capital entering the system than ever to fund startups’ rapid burn rates.

But how will this play out in a challenging fundraising environment, where LPs may limit their exposure to venture in favor of booming public stocks? Or in a graver scenario, where LPs fail to fund capital calls?

Here is what Elizabeth Clarkson, partner at Sapphire Ventures, has to say:

“While I have not heard of many LPs looking to get out of the venture asset class, I do generally expect to see increased LP churn in 2023 and potentially into 2024. Fund managers should expect a tougher fundraising climate… I don’t believe this means emerging venture managers won’t get funded, but I do think the bar has been raised for all venture managers on what constitutes true underlying performance versus high paper valuations.” -

If the above rings true, the ecosystem shouldn’t rely on new money to save it.

Another way to improve the ratio is by changing the capital needs of startups, which is why founders are advised to cut costs and extend runway. But extending runway is difficult and takes time - the overwhelming majority of startups are cash flow negative even after they go public, so being conservative with cash only moves the needle so much. In addition, for many companies, costs scale up with cash raised, further entrenching burn rates. This task is even more daunting for startups with poor unit economics or little cash in the bank.

Looking Ahead

So, where do we go if new money doesn’t come in and startups struggle to cut burn? I see the market playing out in a few ways. Driven by the AI boom, LPs will continue pressuring GPs to invest capital. As mentioned, VC is a high-stakes game measured solely by returns - you can’t generate alpha without investing.

This may result in the following, which are not mutually exclusive:

• Funding of many weak startups

  • No PMF, no sustainable advantage, poor unit economics

• Large mega-rounds in a select few companies

  • Unreasonable valuations, FOMO effects

• A wave of startup failures

The first scenario may already be underway. ChatGPT reached 100m users in record time, and founders began leveraging OpenAI’s plug-ins to develop separate chatbots and applications. Companies like Quillbot, CopyAI, and Writesonic raised millions to create next-generation content platforms. Jasper, a YC company, raised a massive $125m Series A to create marketing materials for businesses.

The problem is these companies are slowing down - their technology is relatively easy to copy and depends entirely on the OpenAI infrastructure. They are also too generic for specific markets. Financial institutions are unlikely to implement these apps into their tech stacks - they will adopt specialized tools trained on their financial data. Healthcare companies will do the same with patient records.

I’m not diminishing the entrepreneurs working tirelessly to deliver products and services that change how we work and live. It’s just important to note that many generative AI startups lack a competitive advantage and will burn a lot of investors on the way down.

The second scenario stems from the broader economy. A frozen IPO market has placed downward pressure on the valuations of late-stage private companies. This hurts growth investors (Series B, C, D) the most, as they rely on M&A and public offerings to generate returns. Given the more attractive risk profile, they may respond and pivot to earlier-stage investing, bringing more dry powder. Excess capital places managers in a difficult position where too much money is chasing too few deals, which drives unreasonable valuations.

This happened with Mistral AI, a four-week-old French startup that raised a whopping $113m Seed round to develop a ChatGPT competitor. This puts a $260m valuation on the company, shocking considering it doesn’t have a product yet, not to mention actual revenues.

There is another way in which startups, in aggregate, become less dependent on cash: they start to fail. The concept is simple – when there are fewer companies to invest in, less money is needed to support those companies. This dynamic played out during the Tech Bubble and the Global Financial Crisis, where the DPR rebounded within a few years following each crash.

No one knows how long the downturn will last, nor how hard it will be for venture firms to raise new funds. Nonetheless, the DPR suggests that the industry has a limited amount of cash, and the idea that existing capital will provide a meaningful buffer to startups is misleading at best.

I don’t mean to sound too pessimistic. There are still plenty of startups with fantastic business models and unit economics. Companies that solve real problems and have great management teams will likely continue to raise capital, regardless of how much dry powder sits on the sidelines.

And yet, it takes time to become a scalable company with product-market fit. It happens quickly for some, while others have to pivot along the way. The DPR ratio evaluates the health of the startup ecosystem as much as it does its time. Not all companies that fail during a downturn would have otherwise. This is why the Dry Powder Ratio is important.

Cheers for reading.