The dry powder fallacy: why there is 50% less startup capital than we think

If there were any doubt startups would experience a tumultuous 2023, the SVB crisis quashed it. Even though we are on the other side of it, many questions remain. The majority of which, though, can summarize as, “What capital is available?”

To answer that, we must look at the whole ecosystem that creates liquidity.

Supply[startup capital] = VC + NTI + VD

We should consider these components individually and together. As both VD and NTI are somewhat dependent on VC. More on this below.

First, venture capital

VCs raise capital, consume some of it as fees, and invest the rest over a period of time. Thus, the capital available to startups from VCs in a rather simple function:

VC=f[capital raised, deployment timeline, reserves allocation, fees and expenses, recycling]

For example, consider a firm that raises $100M. With 2% of fees set aside, they have $80M of cash to deploy. They make initial investments over a 2-year period and reserve 30% of capital for follow-on. This firm would contribute $80M x (1/2) x (1–30%) = $28M to venture capital supply in their first year of investing.

If that firm instead makes initial investments over a 3-year period and reserves 45% for follow-on, they would contribute only $80M x (1/3) x (1–45%) = $15M to the ecosystem. A 50% increase in deployment timeline and reserves cut 40% of capital deployed in year 1. In this case, a difference of over $10M.

Extrapolated across the few thousand active funds, changes in fund strategy create wild swings in overall market liquidity.

We saw market-driving forces influence funds’ investing behavior in 2020–2022. Capital was easier to raise and so VCs did. A prerequisite to raising more capital was investing what you had, so that went faster too. Deployment periods shrunk.

Furthermore, when follow-on rounds become competitive, reserves became less meaningful. So, there was a higher emphasis on initial investment dollars.

To estimate what VCs will invest in 2023, we need to approximate the inputs to the VC formula above: