Historical Perspective - Effect of the Financial Crisis on VC Market

In the research report "Venture Capital and the Financial Crisis: An Empirical Study across Industries and Countries" by Joern Hendrich Block, Geertjan DeVries and Philipp G. Sandner (January 2010), results showed the following key impacts of the financial crisis on the VC market:


1. Lower number of deals: This effect was primarily observed in early stage deals.


The number of first round deals fell by 37.8% (before and during the financial crisis - Table 1) while the number of later rounds fell by 22.9%.


"The lower number of deals in the first founding round is most likely due to stricter investment criteria by VC firms. compared to the period before the crisis, the VC firms have less money to invest, are more critical about their VC investments, and tend to postpone their investments. Not surprisingly, they are less willing to take risks than they were before the crisis. Accordingly, start-ups that still receive VC funding are at later development stages and are, ceteris paribus, thus associated with lower risks (i.e., they might already have developed a prototype or established first customer contacts). Additionally, these entrepreneurs are in a different situation than they were before the crisis. If possible, they postpone their costly development and internationalization plans until the capital markets stabilize. Some entrepreneurs might even refrain from starting a company at all because they do not expect to obtain adequate financing."


Table 1: No. of Startups Funded & Amount Raised by Industry/Stage


Table 2: % Change in Number of Funding Rounds


2. Lower amount of investing: This effect was primarily observed in later stage rounds.


The amount of capital raised in early stage deals fell by 13.5% (before and during the financial crisis - Table 1) while in later stage deals it fell by 20%.


"An important difference between early- and later-stage ventures is associated with the

unhealthy state of the IPO market. VC firms do not provide ‘patient’ capital. Instead, they

intend to sell the firm in which they have invested after a few years. Conducting an IPO

in a recession is not an attractive option. Following this logic, firms at later stages of the

venture cycle become less attractive as investment targets, especially because the

prospects of a revival of the IPO market in the short term are poor. Cumming et al.

(2005) show that when exit markets are illiquid, VC investors invest proportionally more

in early-stage projects. In turn, when exit markets are liquid, VCs invest more in laterstage

ventures. Another explanation not related to valuation issues concerns the process

of staging itself. The crisis and the greater uncertainty about the prospects for the

economy might have increased the tendency of VCs to stage their investments. This

tendency should be stronger with start-ups in later stages of the venture cycle, as the

money at stake for the VCs is larger."


3. Greater Effect on VC Market in US than Elsewhere


"Our empirical study also shows that the crisis had a stronger effect on the VC

market in the US than elsewhere. From a theoretical standpoint, this seems surprising. In

a world of efficient financial markets (Fama, 1970), there should not exist any differences.

VC money is not bound to borders and can flow to wherever the best start-ups

are located. If the crisis led to an external shock in the supply of VC money, the effect on

the amount of deals and investment dollars should be similar in every country. The fact

that the effect of the crisis seems to differ across countries shows market imperfections,

which can be explained by irrational economic behavior and psychological pitfalls (e.g.,

Akerlof and Shiller, 2009; Klodt, 2009). Examples of such behavior are the tendency to

overestimate our own skills (Thaler, 2000), the tendency to pay less attention to information

questioning our decisions than to information supporting our decisions (Brehm,

1956), and the endowment effect (Kahnemann and Tversky, 1979; Knetsch, 1989).

These types of irrational behavior may exist in both the VC market and the financial

market in general. Our results suggest that imperfections in the VC market were greater

in the US than in other countries. Accordingly, the effects of the crisis should also be

greater in the US."


Implications for Startups at Times of Financial Crisis:


  • Fewer Startups Funded - Fewer early stage startups will receive funding

  • Valuation Discounts - Startups that have already received initial funding and want (or need) to raise further funds face a discount as a result of the crisis

  • Smaller Funding Rounds - Startups that are successful in raising funding will receive relatively smaller amounts of capital

  • Stricter Funding Criteria - Startups that seek VC funding will have to fulfil stricter criteria during the crisis than before it

  • Geographical Differentiation - Ecosystems that received the greatest amounts of funding prior to the crisis will be relatively more effected compared with other ecosystems


Potential Role for Governments During Financial Crisis:


The VC market drying up can have long-lasting negative effects with regard to the evolution of innovative industries (Audretsch and Thurik, 2001; Bot1tazzi et al., 2002; Kortum and Lerner, 2000). Innovative start-ups might face illiquidity, and the speed of commercialization of technological innovations might slow down. Ultimately, a country’s or an industry’s path of evolution can be adversely affected. Governments should be aware of these negative side-effects of the financial crisis, as they might determine their country’s innovative capacity. Up to a certain level, governments can have a significant influence on the condition of their national VC market.


Overall, the observed policy responses to the crisis have been designed to avoid a credit crunch (Gern and Janssen, 2009; Sinn, 2009), that is, to avoid a collapse of the credit market for small and large firms. Our results regarding the effect of the crisis on the VC market suggest that this may not be enough: many innovative firms do not rely on debt but rather on

VC as a source of financing. Avoiding a credit crunch helps established (small and large) firms in established industries rather than start-ups in innovative industries.

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