The rise of 'zombie VCs' — Dark times expected after Silicon Valley's startup ecosystem lost its favorite bank

By Jon Swartz

The fallout from Silicon Valley Bank's demise will include the inability of up to half of all venture-capital firms -- primarily small to midsize companies -- to raise their next round of funding, experts say

The fall of Silicon Valley Bank could lead to the rise of zombies.

The bank's implosion exacerbates cracks that had already been forming in venture funding and that will linger for at least two years, a dozen leaders in the venture-capital field told MarketWatch in a series of interviews. This, they say, will lead to dark days for startups that need funding, a change in the relationship between venture-capital firms and founders, and a rise in so-called zombie VCs.

The immediate fallout will be the inability of up to half of all venture-capital firms -- primarily small to midsize companies -- to raise their next round of funding. That's why some are characterizing those firms as the living dead.

"Zombie VCs will be a growing problem over the next 36 months, especially among those who started in 2019 and 2020," said Gianfranco Filice, a venture partner at OVO Fund, which is a pre-seed-stage institutional fund in Silicon Valley whose primary banking partner was Silicon Valley Bank. "They tend to be hobbyists with a handful of employees playing at the early-stage level who invested in friends' companies and took advantage when money was plentiful. They wore rose-colored glasses and got really wealthy without working that hard."

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With a large percentage of VC firms struggling to raise capital, startups that need funds could soon be lurching around Silicon Valley as well. Venture-backed companies were already facing a capital crunch after market volatility forced investors to slow deal-making and set higher benchmarks for financing -- and now startups' debt-financing options have also taken a hit, according to a recent PitchBook note.

"Capital markets had effectively shut down. When things get hard, you find out who is your friend. And for a long time, things were good in the tech market," said Jerry Serowik, managing director at Cohen & Company Capital Markets. "We have moved into an era of being more rational and responsible."

As the first quarter of 2023 draws to a close, CB Insights projects that venture outfits worldwide will report investments of about $65 billion across 6,000 deals in the first three months of the year. That would mark a significant decline from the previous quarter and the lowest quarterly funding amount since 2020, according to the research firm's prior reports.

Companies will also feel the lack of available debt offerings, because Silicon Valley Bank was the largest issuer of venture debt in the startup ecosystem.

"The lack of access to venture debt forces companies to raise equity financing sooner but under less favorable conditions," Brian Lee, vice president of the intelligence unit at CB Insights, told MarketWatch.

"We're seeing a low amount of capital available for every stage and a swift drop-off in deals," said PitchBook senior lead VC analyst Kyle Stanford. He expects a significantly lower number of deals in the first quarter than the 5,200 of a year ago.

What we're experiencing, Lee said, is a reset that started in 2022. The failure of SVB has put downward pressure on valuations and raises the probability that companies that wanted to use venture debt are now losing an alternative to capital and will have to go the equity route. This leads to down rounds, Lee said, referring to financing rounds in which shares are offered at a lower price than they were sold for in the previous round.

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"The cost of capital for startups is going to go higher, both in equity and debt," said Miguel Fernandez Larrea, the CEO of Capchase, a fintech company that assists startups in finding growth capital without watering down their capitalization tables -- charts used by startups to show investors' ownership stakes in the business. He said he considered SVB a "frenemy," because his company both worked with the bank as a client and competed against it.

Days after the bank's failure, about 60% of those in the venture community said they believed the bank's downfall would worsen an already difficult fundraising environment, according to a survey by venture firm NFX of more than 800 founders in its network.

"SVB was ingrained in the ecosystem," saidJyoti Bansal, a co-founder of seed-stage VC firm Unusual Ventures who founded AppDynamics and helped sell it to Cisco Systems Inc. (CSCO) for $3.7 billion in 2017. "It will take two years to fill in the gap that SVB's implosion created in venture debt."

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The startups that are expected to be most affected are consumer financial-technology, or fintech, companies -- the next wave of companies like Block Inc. (SQ), SoFi Technologies Inc. (SOFI) and PayPal Holdings Inc. (PYPL). SVB's clients account for 71% of all fintech initial public offerings since 2020.

"[SVB was] clearly plugged into the fintech ecosystem, with some 2,690 fintech clients," Lee said. "The fallout from recent events may leave a hole in fintech that won't easily be filled. While moving to a new bank for your deposits might be simple, searching for and setting up a payment-rails and -processing partner is a more difficult process."

Venture-capital and private-equity firms that banked with SVB can't yet access uninsured deposits, and if they were drawing lines of credit from SVB, they also can't tap those funds, noted Floyd W. Kephart, the chair of Renaissance Companies Inc., a financial advisory group. Venture-capital and private-equity firms are "in the awkward position of picking winners and losers among their own portfolio base when founders who banked at SVB ask for bridge financing," he added.

"SVB exposed this Silicon Valley club thing, a network in which VCs kept deals private and created a lot of artificial value to continue up rounds," Thomas Carter, CEO of Deal Box, a blockchain-enabled global venture investing platform, told MarketWatch. "To be able to raise that type of money with a pitch deck was crazy."

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Such a dynamic is expected to make VCs much less receptive to entrepreneurs. To put it bluntly, the era of founder-friendly VCs is all but dead.

"The SVB fallout will likely have long-term ripple effects in a way that is long overdue but that could be deemed more challenging for some," said Ben Wright, CEO of the HR technology firm Velocity Global. "VCs are going to demand more thoughtful controls be put in place in areas that may have once been taken for granted. The growth-at-all costs, move-fast-and-break-things approach that absolved companies of taking critical steps to build guardrails and redundancies will find itself [coming to] a head moving forward."

Sand Hill Road -- the epicenter of Silicon Valley venture-capital firms -- "has an image issue," said Tim McCarthy, who is co-CEO of marketGOATS and ran a $10 billion fund in Asia more than a decade ago. "SVB put an exclamation point on it," he noted. "What is the zeitgeist now with all the smart, swinging d--- that didn't turn out to be quite as good or honest as they thought they were?"

The failure of SVB creates a "clear void" in startup-focused services like venture debt, but larger concerns also overshadow the funding environment, such as high interest rates and a recessionary setting, said David Pakman, a managing partner at blockchain/crypto-native investment firm CoinFund.

The impact of the failure of Silicon Valley Bank "is significant but not cataclysmic," Lee of CB Insights said. "This is a hit to an OG in the VC ecosystem, but it's not going to mean necessarily dire times ahead.We also need to consider interest rates and the general economy."

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-Jon Swartz

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04-02-23 1948ET

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