The Impact of the 2008–2009 Fiscal Crisis on Venture Capital

The 2008-2009 financial crisis significantly impacted venture capital (VC). The financial meltdown, which started in 2007 and ended in 2009, affected various aspects of the economy. During this time, businesses incurred massive losses, consumers could not pay their debts, and financial lenders experienced liquidity shortages. It is estimated that Americans lost $9.8 trillion of wealth during the crisis (Merle, 2018). The financial downturn also affected economic growth, including employment. According to Weinberg (2013), the U.S. domestic product declined by 4.3 percent, and the unemployment rate in the country reached 10 percent during the recession. Similarly, the financial crisis of 2008 impacted venture capital financing. The funding of small and medium-sized enterprises (SMEs) fell significantly due to insufficient liquidity. Block and Sander (2009) estimate that the funds raised by each funding round reduced by 20 percent during the crisis. As such, the 2008-2009 financial crisis had adverse impacts on the venture capital market, decreasing funding of startups globally.

This paper examines the effect of the financial crisis on the venture capital market. The report involves the impact of the financial downturn on venture capital firms, entrepreneur founders, and limited partners (LPs). Ideally, there is a strong relationship between VC markets and the financial sector. The VC is a part of the financial market. This means that any change in the financial sector leads to a substantial impact on venture capital financing. Zhang et al. (2019) indicate that venture capital is vulnerable to economic recessions and financial turbulence. For instance, the onset of the financial crisis in 2007 made it difficult for VC firms to raise funds as part of the private equity market. Similarly, the firms exited the start-up businesses without adequate returns (Zhang et al., 2019). Usually, venture capitalists derive their capital gains from startups after investing for a period ranging between two and seven years.

The negative impacts of the financial crisis extend to startups. New businesses are likely to fail since they cannot raise sufficient capital through VC financing. According to Eisenmann (2021), most new businesses fail, and two-thirds do not deliver positive gains to investors. The problem is expected to be severe when VCs fail to raise enough capital for these companies. Moreover, the impact of the fiscal crisis on venture capital affects the initial public offerings (IPOs). It delays the businesses from going public due to insufficient capital and assets. VC backs up to 60 percent of the IPO in the U.S. stock market (Zhang et al., 2019). As a result, a decline in the venture capital market can adversely impact the stock market.

Despite the significance of venture capital on the overall economy, a few studies focus on the impact of the financial crisis on this market. Therefore, this study attempts to bridge the existing gap in the literature. It also creates a foundation for future studies.

This study aims to establish the impact of the 2008-2009 financial crisis on the venture capital market. Some of the questions used to examine the topic include:

Did the financial crisis lead to a decline in funds invested by VC firms?

How is the crisis associated with the drop in funds raised in each financing round? What was the size of the decrease?

What was the effect of the financial crisis on the first and last financing rounds?

The literature review section analyzes various studies related to the issue. It covers the existing literature and data on the impact of the financial crisis on the venture capital market in the United States and other parts of the world. The literature also entails the definition of key terms and concepts used in the paper.

A financial crisis refers to a situation whereby the value of the financial instruments and assets reduce significantly. When this event occurs, asset prices reduce, causing businesses to incur losses. It also depletes consumers’ wealth, reducing their ability to pay debts. This causes liquidity shortages among financial lenders. The 2008-09 financial crisis started in 2007 and ended in 2009 (Weinberg, 2013). When the housing market in the United States in 2006, residential construction started declining. The losses related to the housing market collapse were realized in 2007 when the global financial markets experienced a strain from the mortgage-backed assets (Weinberg, 2013). The problem soon spread to other areas of the economy. The 20008-2009 financial crisis led to the loss of wealth and property as the stock market plummeted. According to Merle (2018), Americans lost $9.8 trillion in wealth following a decline in home value and retirement accounts. Ideally, the financial turbulence started when Freddie Mac and Fannie Mae extended home-ownership mortgages to low-income consumers (Trevino & Nelson, 2021). The approach increased risks in the financial sector and the housing market's collapse.

The financial crisis of 2008/2009 is associated with multiple causes. Trevino and Nelson (2021) suggest that the global financial downturn resulted from unethical practices and behaviors. Businesses in the United States went against ethical practices such as fairness, transparency, and responsibility, leading to an economic disaster. One of the identified causes of the financial crisis is the housing bubble in the United States. Before the financial problem, the U.S. housing market had experienced unprecedented growth in the decade. For instance, the home ownership rate increased from 64 percent in 1994 to 69 percent in 2005 (Weinberg, 2013). Similarly, the investment in the residential sector reached 6.5 percent of the U.S. gross domestic product (GDP) during the same period. The expansion in the housing market led to increased home mortgage borrowing. As of 2006, the housing debt among U.S. households accounted for 97 percent of the GDP (Weinberg, 2013). The interest rates were also low, encouraging many Americans to borrow. Essentially, investment became an investment of choice. Soon housing prices skyrocketed, and the demand exceeded supply (Trevino & Nelson, 2021). At this point, lenders and consumers anticipated the growth would continue. However, in 2006, housing prices peaked, and the market started declining, leading to the financial crisis.

The availability of subprime mortgages also led to the financial crisis. Subprime mortgages refer to loans extended to high-risk consumers (Coghlan et al., 2018). These are mortgages that are rated B/C. The issuance of subprime mortgage loans started in 2003 when the market became saturated (Coghlan et al., 2018). Financial lenders gave out low-quality loans in order to continue generating profits and competing favorably. This led to an increase in financial organizations with low-quality loans. At least 45 percent of the large corporation were involved in the unconventional MBS market by 2006 (Coghlan et al., 2018). The chart below indicates conforming and subprime loans trends between 1995 and 2007.

Source: Coghlan et al. 2018

Moreover, a lack of strong regulation in the financial industry contributed to the financial crisis. There were no regulations to prevent large financial institutions from engaging in subprime mortgage loans (Block et al., 2010). The relaxation of the net capital rule in 2004 allowed more banks to assume more debts than their assets. Regulators and legislators are largely blamed for this outcome. For instance, the Congress repealed Glass-Steagall Act, allowing banks to engage in risky investment, aggressive, and predatory cultures (Trevino & Nelson, 2021). Significantly, predatory marketing tactics and fraudulent activities aided the financial market's collapse. According to Coghlan et al. (2018), mortgage originators enticed customers to take loans by deceiving them about eligibility and loan terms. The concept of ‘liar loans’ encouraged investors to borrow more and refinance real estate investments (Trevino & Nelson, 2021). Many homeowners lost their wealth and defaulted on loans when house prices fell. These activities collectively led to the financial crisis in 2008.

The government regulators and the private actors ignored early warnings, issues, and problems that influenced the financial crisis. The Federal Open Market Committee (FOMC) downplayed the severity of the housing market vulnerability. For instance, they kept the federal fun rate low for a prolonged period, leading to low-interest rates (Weinberg, 2013). This encouraged many people to secure mortgage loans, causing the housing bubble. FOMC considered the fluctuation of housing prices as a matter of demand and supply forces. They assumed that the occurrences in the housing market were distinct from those in the financial market (Coghlan et al., 2018). The FOMC was blinded by the events. Even after Lehmann Brothers' bankruptcy, the committee still did not take concrete action. The crisis could have been prevented by implementing strict monetary policy at the early stages to curb the housing boom.

Loose regulations in the financial industry also allowed banks to trade in hedge funds by demanding more mortgages to support skyrocketing demand in real estate. The interest-only loans made borrowing affordable to subprime borrowers, who later defaulted on their mortgages and derivatives. These problems could have been avoided by carefully assessing the creditworthiness of borrowers, monitoring the soundness of securities, including securitized mortgage products, and purchasing bad loans by the government.

Another issue that could have been avoided to prevent the crisis is the failure of risk management practices in the banking industry. Although the crisis resulted from multiple causes, it was partly contributed by the internal corporate governance and infrastructure failures (Baily et al., 2008). Decision-makers in the banking sector failed to take action to prevent the financial crisis. Some banks did not follow risk management rules when dealing with collateralized debt obligations (CDOs). This is because they were generating a lot of profits from the operations. For instance, financial companies accepted credit ratings from agencies without background checks and verifying the information, resulting in bad mortgage loans. These problems could have been avoided if banking institutions had fully implemented risk management practices.

Since the 2008-2009 financial crisis, several changes have been made in the private and public sectors to prevent similar incidents in the future. The U.S. government took unprecedented interventions to address the financial crisis. It also implemented changes and financial policies to provide guidelines for future events. For instance, the Fed initiated large scale asset purchase (LSAP) programs to reduce longer-term public and private borrowing rates (Rich, 2013). The government purchased mortgage-backed securities (MBS) to reduce the cost of housing and increase their availability. These changes were complemented by traditional interventions such as lowering federal fund rates to zero (Rich, 2013). These actions have helped in curbing the financial crisis.

Federal Reserve, central banks, regulators, and policymakers undertook various measures after the 2008 crisis. These institutions were forced to adopt more effective and safer policies, including adjustments in bank structure and capacity, developing reliable and relevant valuations and disclosure of risks, building resilience and monitoring money in circulation. The Financial Stability Board (FSB) created an implementation monitoring regime to ensure agreed reforms were implemented. Today, banks have become highly capitalized, and less money flows around the global financial system (Lund et al., 2018). Also, Fed was given more powers to make systematic changes on shadow to cushion banking systems and protect consumers. The government created The Dodd-Frank Act to strengthen regulatory measures in the financial industry.

Similarly, the private sector has made critical changes that will prevent similar incidents in future. Credit rating agencies developed new rating methodologies. For instance, they separated the rating of structured products from other business activities (Sacasa, 2008). The code of Conduct Fundamentals for Credit Rating Agencies was also revised to combat conflict of interest and improve the quality of the rating process. Banks also strengthened their risk management models to reduce excessive exposures, uncertainties, and risk concentrations.

Venture capital is a form of private equity financing. VC financing provides funds to startups and small businesses that support their growth. In most cases, venture capital is given to companies perceived to have long-term growth potential. For instance, VC is used to finance innovative companies during their early stages of product development and commercialization (Block et al., 2010). These funds are generated from investment banks, investors, and other financial institutions. The capital is allocated to companies with a high potential of payoff. Usually, VC firms exit the company after receiving capital returns from their investments in the company. The investment period ranges from two to seven years (Zhang et al., 2019). However, they ensure that the companies have achieved intended growth and maturity before exiting. After successful exits, profits from the investment are channeled back to limited partners (Janeway et al., 2021). Besides providing funds to startups, VC firms also offer technical and managerial expertise to small businesses.

The venture capital market has recorded significant growth in recent years due to innovative companies in the United States and other parts of the world. VC has provided funds to prominent IPO companies. According to Janeway et al. (2021), venture-backed companies constitute 50 percent of all initial public offerings. They account for 75 percent of market capitalization and research and development (R&D) investment. Therefore, venture capital is crucial for economic growth and technological development.

The financial crisis of 2008-09 had a negative impact on the venture capital market. Typically, the crisis caused liquidity shortages in the financial market, which spilled into the venture capital. Since VC is a part of the financial sector, it was affected directly by the economic downturn. This is demonstrated by the reduction of private businesses that receive venture capital funding. Janeway et al. (2021) indicate that only 0.5 percent of startups in the United States access VC financing every year. The decline in venture capital volume extended to new businesses is attributed to stringent measures implemented during the financial crisis. According to Zubair et al. (2020), the crisis caused commercial banks to tighten debt supply to private companies, increasing financial constraints and reducing investments. Ideally, the financial sector's collapse was associated with large debt extended to low-income consumers and private firms.

The financial crisis significantly reduced venture capital funding. The amount of funds raised in each round of VC funding declined during and after the financial crisis. For example, the total funding volume in August 2008 was $972 million, and it dropped to $499 million in November 2008 (Block & Sandner, 2009). The monthly funding also reduced substantially during the crisis. The decline of VC funding is connected to strict financial policies introduced during the financial crisis. The figure below shows the VC funding of internet firms before and during the crisis.

The financial collapse also caused a decrease in the amount of funds raised per funding round. The reduction was more pronounced in later rounds of funding. Ideally, there are three main funding rounds. These include series A, B, and C. These funding rounds represent the growth process among startups due to external investment. A study by Block and Sander (2009) shows that companies raised 20 percent less funds in their later rounds during the financial crisis. Those at the early stages of development also received reduced funding. The financial crisis led to the lower valuation of startups because the economic slowdown impacted their potential of generating profits. In response to this situation, VC firms reduced their investment in these companies to avoid risks and losses.

Crucially, the crisis disproportionately affected some firms than others. For example, the internet, medical, media and communication, and computer hardware industries were adversely affected (Block et al., 2010). The biotechnology industry was least affected by the disruption of VC finding by the financial crisis. The explanation behind the scenario is that VC firms did not have sufficient funds to invest in private equity because the crisis affected financial institutions that provided them with funds. Notably, most VCs are pension funds, banks, and insurance firms. So, when the crisis hit, they could not access enough funds from investment banks since most of them were making losses or bankrupt (Block et al., 2010). They were also forced to cut down their investment in risks portfolios such as VC funds. These changes culminated in the reduction of VC funding volume and the amount of funds obtained in each round.

Moreover, the strict regulatory measures and economic restructuring lowered capital accumulation, affecting current players, including VCs, LPs, and entrepreneur founders. For instance, the credit constraints have slowed capital allocation and locked resources in unproductive activities, hurting investors’ growth. Also, the shift in attitudes towards risks triggered by tight credit conditions and increased capital costs have curtailed physical investment and innovation.

VCs and entrepreneurs protect themselves by doing due diligence, building a network with good startup counsel, and filing federal intellectual property registration. Venture capitalists utilize business concepts and plans, risk judgment, market opportunity, and management teams to evaluate new ventures. This set of criteria allows VCs to mitigate risks by connecting funding with the right entrepreneurs.

VC firms also protect themselves from bad investments by vetting their entrepreneur founders. They consider numerous qualities in a founder before agreeing to invest in their startups. For example, VCs look for self-awareness and intellectual integrity (Ghosh et al., 2021). They understand that introspective founders are likely to lead a successful business. They also consider founders who have in-depth knowledge about their business model and clearly communicate the business strategy to potential investors, partners, employees, and customers. These approaches help VCs avoid financial losses due to startup failures.

Entrepreneur founders have business ideas that can be transformed into a product or startup. They obtain venture capital financing by hunting for capital ventures, evaluating them, negotiating and executing the plan. VC funding occurs at different levels of business development. These include seed capital, startup capital, early-stage to the third phase, and expansion stage capital. Entrepreneurs should choose capital ventures that ensure sustainable capital and foster economic growth. Overall, building relationships with leading VCs can promote an entrepreneurial community that helps spur start-up activity.

The financial crisis of 2008 had a devastating impact on the venture capital market. It affected the financial market, leading to a decrease in VCs’ funds supply. In turn, this reduced the ability of venture capital firms to fund startups and small businesses. The outcome of these events was a significant decrease in VC activities. They also caused a decline in VC funding volume and the amount of funds generated in each funding round. Similarly, traditional and nonconventional policies and interventions implemented during the crisis led commercial banks to impose strict rules on debts. They discouraged investment in risk ventures such as VC funding. As a result, the crisis had far-reaching impacts on the venture capital market.

Baily, M. N., Litan, R. E., & Johnson, M. S. (2008). The origins of the financial crisis. Brookings, https://www.brookings.edu/wp-content/uploads/2016/06/11_origins_crisis_baily_litan.pdf