A top VC predicts the industry is heading for a massive and enduring contraction

• The venture capital industry could face a big contraction in the near future.
• Thats's according to Scott Stanford, cofounder and partner at ACME Capital, an early-stage VC firm.

It's no secret: Venture capitalists are hurting.

A slowdown in VC deal activity, which started in late 2022, has continued into the first quarter of this year, accounting and advisory firm EisnerAmper wrote in an analysis published on June 16.

You've heard this story before: inflation, interest rate uncertainty, and low M&A volume are having chilling effects on the investing environment.

Venture capital has cyclical fluctuations, but Scott Stanford, a cofounder and partner at ACME Capital, an early-stage VC firm, thinks something more meaningful is underway.

"It's not crazy to think half the VC firms that were actively investing in the last decade will be sidelined and eventually collapse," he wrote in an email to BI.

The first wave will die off in the next five years. Ten years from now, the damage will be evident, he said.

Some simple back-of-the-napkin math paints a grim picture.

In a chart compiled by Stanford and shared with BI, by 1990, there were 300 VC firms overseeing $17 billion in assets. Over the last two decades, those numbers went through the roof. Now, there are 3,000 VC firms overseeing $1.2 trillion.

By contrast, the increase in exits is modest at best. By 1990, VC-backed IPOs totaled $12.7 billion. By 2021, that increased to $60.1 billion. And it's a similar story with VC-backed M&A deals.

The venture industry got ahead of itself, in other words: The proliferation of firms and the money they're managing is not supported by the financial value they're creating.

"As the venture capital industry matured over the past several decades, euphoric momentum investors, not technologists, drove the creation of funds and the deployment of capital, blind to the nuances and challenges of timing innovation cycles," Stanford and ACME cofounder Hany Nada told investors in a recent letter shared with BI.

"Just as investors mistime specific investments or funds, the venture industry as a whole got as much as a decade or two ahead of reality, leading to an overcrowded, overcapitalized, and overvalued market," they added.

VC backers have other options

Other factors will serve to cull the herd in VC, per Stanford.

Limited partners (LPs), or investors who put money into venture firms, have other options thanks to higher interest rates, Stanford added. Low-risk investments like investing in Treasury bonds, for one example, are commanding a decent return.

Tech, meanwhile, is "no longer an elusive sprite commanding irrational M&A premiums or IPO exuberance," Stanford said.

Once upon a time, a startup claiming they were a tech company somewhere in their pitch deck might command a billion-dollar valuation. That era is long gone.

Finally, AI isn't necessarily the next panacea, Stanford said.

The jury is out on whether it spawns the next generation of unicorns — when leaders like OpenAI are providing the tech openly, and anyone can use it to spin up decent products.

All told, in this environment, investors without deep expertise, powerful networks, or mega-funds to deploy will be hard-pressed to raise money and build enduring franchises, Stanford said.

"A VC without capital is like a tennis player without a racquet," he said. "They can give interviews and make headlines but they aren't invited on the court."

VCs will have to take risks again

Stanford believes today's challenges will give way to a new — or, rather, an old — era of VC investing.

Tons of startups that went to market in the last handful of years had a similar strategy: Backed with millions in funding, they launched an app that was slightly better than someone else's.

In the past, you could get away with making social features, apps, and incrementally better software in this fashion, Stanford said.

Nowadays, incumbents can do all that themselves.

So, investors that survive the contraction will have to back companies that are actually inventing things and therefore come with a sizable risk profile.

When those companies get it right, they generate outsized returns. When they get it wrong, they go to zero.

Maybe these VCs can be part of what Stanford describes as a renaissance of technology, "where systems work for us versus us working for them," he and Nada wrote to LPs.