Investors in the startup ecosystem are growing more and more concerned about the rise of zombie funds.
Currently, the venture capital space is at risk of experiencing substantial consolidation. As startups face increasing pressure to locate fresh capital, they are stunted by limited investment opportunities as investors hold tighter onto their funds.
All of these factors appear to be reshaping the industry’s investment dynamics. Leaving many to ask where the overall industry is headed.
What is a Zombie Fund?
At its core, zombie funds are firms that are in a state of stagnation, managing existing portfolios but lacking the capital to fund new ventures.
“Venture funds don’t really die away quickly.” Dr. Josh Lerner, professor at Harvard Business School with a focus on venture capital. “One of the big reasons is that typically these things have lives of roughly a decade.”
He says that as long as the fund is still operational, its managers are going to be collecting management fees. “In other words, they’re in business, they’re still collecting fees, but there’s not a lot of optimism about their future.”
The current economic landscape, with rising interest rates and growing recession concerns, is accelerating the issue further. Venture capitalists predict that hundreds of firms may fall into zombie status in the coming years, as limited partners pull back from riskier or underperforming funds.
Latest VC Numbers
The significant and growing presence of zombie funds highlights both the limitations and complexities in an uncertain economic market–as the Nasdaq remains down by roughly 26% from its peak in November 2021.
In one concerning data point, “down rounds,” or when a founder raises at a lower valuation than a previous round, were still at near record highs through the first half of 2024, Aumni’s Venture Beacon reports.
But the market holds some bright spots. Crunchbase data shows a resurgence in large funding rounds ($100 million or more), while seed and Series A valuations have shown modest improvement.
The PitchBook-NVCA Q3 Venture Monitor indicates that dealmaking in 2024 is on par with 2023, at nearly 16,000 deals, resembling pre-pandemic levels and the pace before the 2020-21 boom.
But the consistent fall in VC participation signals a significant consolidation of the venture market. This investor decline marks the lowest rate in a decade and signals a substantial shift.
Overall, the VC landscape saw a 25% drop in active investors from 2023 to 2024, falling to 11,425 deals.
Why the Spike in the Zombie VC?
The rise of these funds is fueled by several economic factors, including high interest rates, limited fundraising options, high debt burdens, and reduced returns on prior investments. But this also reflects a broader market recalibration where venture-backed startups and VCs alike must adapt to reduced capital flows.
The steep drops in tech valuations have made these backers more selective. PitchBook data from 2024 indicates that 13% of US venture capitalists do not plan to raise additional funds, while 27% have postponed fundraising efforts.
But in context with a historical backdrop, the latest figures aren’t actually too surprising.
Dr. Lerner explains how venture tends are a “pretty cyclic industry” and typically goes through these periods of “frenzy” and “over enthusiasm”, then followed by a correction (dip in the market). And then, as he puts it, the crazy behavior gets weeded out, and then it repeats itself.
“I think it’s fair to say that these patterns of boom and bust have been part of funding new technology since as long as we have records,” he says, pointing to the rise of electricity in the 19th century. “It just seems to be part and parcel of the territory.”
It became clear that many public company valuations of venture-backed firms were heavily inflated, leading to significant corrections, he continues. But instead of an immediate flip, many “didn’t want to face the music that they were massively overvalued.”
Best Chance for Survival
Flexibility and adaptability will become more vital skills than ever in the coming years, especially if you find yourself working from within. Dr. Lerner explains how being caught up with an investor who can’t participate can be more than challenging–it can be a stain on a business.
In the years ahead, flexibility and adaptability will be essential, especially if you find yourself attached to a zombie fund or investor. But having an investor unable to participate in new financing rounds can be more than just difficult—it can tarnish a business’s reputation.
“In many cases, if you have an important investor and there’s a new financing round and your investor is not participating, it’s seen as a very bad indicator by other investors,” Lerner notes. “People look at that and say, well, the other guy didn’t invest.”
Securing a reputable, established investor from the start is ideal,. However, Dr. Lerner acknowledges that such situations are sometimes unavoidable. By this point, it’s about making the most of your current situation and prepping for increased skepticism from potential backers.
“Ultimately, if you have something that’s achieving product market fit and having real success, hopefully the fundraising difficulties or the difficulties of your lead investor will not be enough to overshadow the kind of success that you’re having.”
About the Author: Tess Danielson is a journalist and writer focusing on the intersection of technology and society.
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