Venture debt will be big for startups in 2023 - and could break the bad habits of the boom years

Startups are facing a problem in 2023: Nobody wants to give them money — at least not in the way they’re used to.

Fundraising from venture capital is expected to slow in 2023 as the tech slowdown continues. From the third quarter of 2021 to the third quarter of 2022, startup funding from venture capital fell by 54%, to $74.5 billion from $164 billion, according to PitchBook.

Without more traditional venture-capital funding, startups are increasingly turning toward venture debt, taking out three-year loans to raise capital.

While some worry that the trend toward debt will stifle innovation, a growing number of VC investors and startup founders think it will encourage new ways of thinking. In their view, venture debt will break the bad habits of a generation of free-spending startups and create a new breed of companies focused on execution and market fit over blitzscaling or promising to change the world.

Rakefet Russak Aminoach, a managing partner at Team8, suggested that the pressure of debt and less capital overall forces companies to home in on things that matter.

“When you have a lot of money, you are less cautious of how you spend it,” she said. “But when there is not a lot of it, it sharpens the mind, and you become more accurate on where to put it.”

In the funding crunch of mid-2022, VCs told portfolio companies to focus their products and get disciplined about spending. This was markedly different from 2021, when it seemed as if every startup raised money at record valuations.

Anna Barber, a partner at M13, argued that that environment was detrimental to new companies because they immediately needed to try to live up to those inflated valuations.

“Without the artificial pressure of valuations disconnected from performance, we’ll see founders who are really focused on finding product-market fit at the earliest stage and solving problems for actual customers,” Barber said.

Barber added that some startups benefit from being unable to increase headcount immediately. A startup still looking for market fit can be more nimble with a smaller team and quicker communication.

Other investors believe that a funding crunch will create fewer startups but that those startups will be forced to be more innovative.

Aminoach said there’s a higher bar for startups now to prove they’re worthy of getting money. Both equity investors and venture-debt lenders are demanding more before giving money to startups, forcing founders to clarify how they plan to beat the competition and find profit margins.

Aminoach added that the boom times of 2020 and 2021, with record numbers of venture investments, could’ve also stifled true innovation.

She pointed to digital banking as an example of an industry that over the past few years became filled with companies that catered to different niches but had little differentiation in their business models, making it difficult to see what was truly innovative.

“When we look at the last few years, everyone had FOMO and wanted to invest in the next big company,” Aminoach said. “But that made a lot of copycat companies because money was so easy to get. And that’s not innovation — that’s noise.”

Originally published in Insider, Jan 3, 2023.