Analyzing the Dry Powder Ratio
There is no magic threshold for what the Dry Powder Ratio should or should not be. Instead, the Dry Powder Ratio illustrates where we are today relative to prior periods.
As is evident in Figure III, the amount of dry powder relative to annual deal value has significantly contracted in the last two decades. Looking even further back, the current Dry Powder Ratio of sub-1.0x stand in stark contrast against the 1981 – 2001 average of 2.3x as well as the prior trough at the height of the Dot-Com Bubble.
The decline in the Dry Powder Ratio represents an unprecedented shift in the U.S. startup ecosystem. If the capital needs of startups remain constant, the $290bn surplus of dry powder will not last longer than a year. In other words, U.S. VC funds are more reliant on new capital entering the system than ever before.
Of course, the capital needs of startups do not remain constant. This is why, for example, founders are being advised to cuts costs and extend runway. Furthermore, it’s possible that average startup runway is longer today than during prior downturns, due to the sheer amount of capital that was raised by companies prior to the downturn.
However, while there are a few caveats to the recent trends in the Dry Powder Ratio, those caveats are likely limited in scope. First, extending runway is not something that can be completed overnight. The overwhelming majority of startups are cash flow negative (even in the years preceding and following IPO), so being conservative with cash can only take you so far, especially if your company already has little cash in the bank or your business model has unprofitable or unscalable unit economics. And second, for many companies, costs have scaled with the cash they’ve raised, resulting in negligible impact to runway.
It should also be noted that there is another way in which startups, in aggregate, become less dependent on cash. Companies fail. The math is simple – when there are less companies to invest in, less cash is needed to support those companies. This dynamic played out during the Dot-Com Bubble and was one of the driving factors for the rebound in the Dry Powder Ratio within a few years following the crash.
We do not know how severe the current downturn will be. We do not even know to what extent VC firms will struggle to raise new funds. Nonetheless, the Dry Powder Ratio indicates that we have entered the current downturn with a limited amount of cash, and the notion that existing dry powder will provide a meaningful buffer to startups is misleading at best.