How will VCs manage dry powder this year?
By Babbage
This blog is based on a venture capital industry concept known as dry powder. As such, the blog runs the risk of traveling into issues that many startup teams might find a tad boring and esoteric.
To address this, we’ve arranged the blog as a little script for a short scene, starring yours truly, Babbage, and a prospective founder seeking a Series A investment. The short scene takes place at a bar in New York City.
And no – we did not use ChatGPT to generate the narrative – although we do approve mightily of such action if it produces a better result. Readers are welcome to issue a specification for this scene to see if something nicer comes from our chatbot friends.
SCENE: A table just off the bar at SIXTY SoHo in New York City. The lights are low and soft jazz is playing just enough to be heard, but not so much to impede conversations. A Manhattan runs about $40 in this posh place, even with an average bourbon.
Babbage is seated across from a woman named Andrea who has recently completed her PhD in Computer Science and Engineering from NYU. Her expertise is AI, and she has built a prototype that secures machine learning from insider bias attacks.
Babbage has had a long friendship with her advisor, a well-respected academic, and at the advisor’s request, the two are meeting to discuss her idea for a new company.
ANDREA: (Sipping a water) Thanks for meeting with me.
BABBAGE: (Sipping the overpriced Manhattan) Your advisor and I have known each other for about a hundred years. I trust her judgment.
ANDREA: That would make you roughly 120, wouldn’t it?
BABBAGE: Most people who read my blogs figure I must be about that old.
ANDREA: (Nodding) Well, it’s nice to meet you. But I have to say that with this issue of dry powder, I expected you might cancel.
BABBAGE: Dry powder – wow, I hadn’t expected that to come up. What do you know about dry powder?
ANDREA: Actually, to be honest, not much. Other than that my advisor tells me that it’s causing VCs to be a little cautious about investments. She told me that this will be a tough year. Is this true?
BABBAGE: I guess I can try to explain, but you might need something stronger than water.
ANDREA: (Noticing the waiter walking by) Uh, excuse me, could I have a Manhattan?
(The waiter nods and glances over at Babbage who smiles and motions for another ridiculously priced Manhattan.)
BABBAGE: OK, here’s how it works. Dry powder is nothing more than money kept in reserve, which we can use for new investments when we see fit and for follow-on investments in companies that are working well. And your advisor is correct, right now venture capital investors in the U.S. might be sitting on something like half a trillion in uninvested dollars.
ANDREA: That seems like good news for new companies.
BABBAGE: Well, actually it’s bad news. The conditions that drive excessive dry powder are, by definition, the ones that reflect less excitement about investing.
ANDREA: Do VCs just put all this dry powder in the bank?
BABBAGE: Dry powder sometimes consists of cash, so yes – some of that might be sitting in the bank. But most dry powder is in the form of uncalled capital from LPs (limited partners who are the investors in the venture fund). So it’s sitting in someone else’s account or maybe found in equity positions held by LPs. This dry powder gives early-stage firms like ours, a lot of flexibility to invest if the conditions become right.
ANDREA: Like if you hear an amazing AI pitch from an NYU grad – right?
BABBAGE: (Smiling) Touché. Anyway, what caused the dry powder we have now in 2023 is that startup investments seemed to be getting a bit out of whack, especially in cybersecurity. The other thing is uncertainty and an IPO window that is all but closed for technology companies. Investors hate uncertainty – and VCs are being careful. Later-stage firms, in particular, need to keep a lot of reserves in times like these. Their portfolios have large, pre-IPO companies that may need to postpone an IPO until public markets become more welcoming. These large companies require large amounts of capital and those VCs don’t want to lose their winners due to capital risk.
(Just then, the waiter brings over the two drinks and removes Babbage’s empty glass. Andrea takes a sip and sets down the drink. Babbage nods a “thank you” to the waiter.)
BABBAGE: (Continuing) So, all this uncertainty in 2023 comes from many different directions. First there is the war in Ukraine. This might not sound like an issue for an AI startup, but it affects the macro-economic environment, so it is a factor.
ANDREA: That war is terrible.
BABBAGE: (Nodding) Yes, it is. And we all hope it ends soon. In addition to the war, there is the likelihood of recession this year. That creates concern that only the best ideas can thrive in a tough selling environment. So, we are more careful.
ANDREA: Are interest rates an issue?
BABBAGE: Yes, they are – but it’s not always obvious how. On the one hand, when rates are low, VCs offer excellent options for investors. But when rates are high, the general business environment is tougher. There is more competition for investment dollars and some of it flows into “safe” places that now provide decent returns in the form of interest. When interest rates are expected to remain elevated for a long time, the future cash flows of technology companies are simply less valuable – inflation lowers the value of those future dollars and equity markets shy away from the sector. Basically, everyone hates uncertainty – and we have a lot of that right now.
ANDREA: What do you think will happen?
BABBAGE: There’s always pressure on VCs like us to invest the money that’s been raised in truly great companies. So, the best approach for startups is to just continue to be creative and aggressive, and there’s no reason why they shouldn’t see good results this year.
ANDREA: So, getting an investment this year should be easy?
BABBAGE: (Leaning forward) Pardon?
ANDREA: I said that maybe getting an investment in cybersecurity this year should be easy.
BABBAGE: (Pausing) Yes, as long as you are the one-in-a-thousand that gets a term sheet, you should be just fine.
ANDREA: (Downs the Manhattan and motions to the waiter for another…)