There is a lot of uncertainty about the state of the private, high-growth technology markets and the venture capital markets that underpin them. On the one hand innovation is clearly at an all time high unleashed by smart phones, fast telecom networks, social networks that spread commerce and the fact that we are all one click away from buying things on Amazon, Apple, Google or PayPal.
In 2012 I penned an article called “It’s Morning in VC” that highlighted many of these trends and in 2014 I published a series of data in this VC SlideShare presentation of “Why VC is Much More Compelling” now, which updated many of our earlier analysis.
Fast forward 3 years and looking out into the 2016 horizon, what do I see? Perhaps I would call it “Mourning in VC” as in mourning for the days of rational behavior. There is nobody to blame for this abandonment of common sense – it is simply the market being the market and we’re doomed to repeat history. Boom and bust. Great technology firms were built during the last dry period and we saw the huge wealth creation of Facebook, Twitter, Tesla and others. The cycle before that was Google, Salesforce and LinkedIn, amongst others.
Technology riches yield bumper crops in venture capital with new firms and new largesses – the rewards of LPs rediscovering our asset class. Are LPs to blame? Are VCs? Or the influx of massive new amounts of entrepreneurs and wantrepreneurs seeking fortune and fame? None of these. It’s just a market. It’s like blaming the media for incessantly covering Donald Trump and then watching the ratings when Donald Trump is at a debate and being surprised that the media gives him so much coverage. Markets are markets.
Our late-stage, privately held technology market is clearly in a bubble. Here is the Wikipedia definition of a bubble
“Trade in an asset at a price that strongly deviates from an asset’s intrinsic value”
The arguments against that, “This time the startups have real revenues!” or “Only private markets have increasing value so it can’t be a bubble!” ring hollow. “A price that strongly deviates from an assets intrinsic value” is pretty clear. The market has yielded what investment guru Michael Moritz recently termed “subprime Unicorns.” How elegantly stated.
“A surge in prices, more than warranted by fundamentals & usually in a particular sector. Followed by a drastic drop in prices as a selloff occurs”
A surge in prices. More than warranted. Usually in a particular sector. So let’s examine the data a little bit more closely.
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I spoke last week at the annual Cendana VC/LP conference. Cendana founder Michael Kim was amongst the earliest and certainly the most focused LP to spot the changes in venture capital leading to seed stage funds and has backed many of the best in the industry so it’s always a pleasure to come and share thoughts with all of these great peers. My presentation from the Summit can be downloaded here and the embed is below but the summary message is the rest of this blog post
If “the market” is driving up prices beyond intrinsic value the main new entrants to the market that have taken a less rational view of historical prices are a series of “non VCs” including corporate investors, hedge funds, mutual funds and crowdsourcing. Note that I’m not absolving my industry, venture capital, from bad behavior. I’m merely pointing out that price drivers are more strongly correlated with outsiders. On the chart below, 78% of the rounds of 80 $1bn+ companies were led by non VCs.
To give you some perspective of how quickly we’ve created a “subprime Unicorn market” (as Michael Moritz called it) consider that in the last 18 months in the US alone we’ve gone from 30 privately held technology companies worth more than $1bn (already considered high by some) to more than 80 companies just 18 months later. Either we’ve discovered magical beans and elixir or perhaps we’ve gotten ahead of ourselves on valuation. Here is a chart to show you the median valuation of late stage private tech companies compared to traditional growth rounds of capital led by VCs and also vs. the public markets.
And when you begin to unpack what some of the drivers are behind the rise of the subprime Unicorn club you can trace the money to a handful of sources. First, corporate investors including Google, Rakuten, Alibaba, Comcast and others have increased their investments in venture and often don’t have the same profit motive (and thus pricing motive) as traditional investors. This isn’t a damning statement or indictment of corporate investors – it just should be acknowledged that often there are strategic reason for making investments beyond what a purely financial investor would be expected to do.
Perhaps what’s most interesting has been the moves by mutual funds and hedge funds to get into the private capital markets. As I pointed out in this post about the changing structure of the VC industry, private tech companies are delaying IPOs and thus privately held tech investors are reaping more of the value prior to an eventual IPO so public investors must have felt compelled to respond.
Mutual funds have poured large amounts of capital into what they perceive as the next peer group of public companies and one insider described it to me as simply “buying their IPO allocations now since they will need to own the stock once it’s public.”
In just two years the median round sizes for deals with mutual funds has more than tripled and the same phenomenon holds for hedge funds. So what we can say is that a whole lot of money is sloshing around in the late-stage tech ecosystem. This must be a boon for entrepreneurs of fast-growing tech firms – right? Right?? Not so fast. It turns out that companies eventually must have their day of reckoning. They must either eventually IPO or they must be bought by larger companies who almost certainly themselves are public. So eventually rationality has to occur.
Public market investors are not the fools many private investors like to play them out to be. Of course they built protection into many of their financings that allows them downside protection against IPOs if the price is lower than the price they paid. So is the price they are paying today for a $1bn plus company rational? Is it really worth $1bn+ or as Michael Moritz put it – have we created some sub-prime unicorns?
As usual – the markets offer us some indication. In 2014 3 out of 12 exits were occurred at a lower valuation than the previous round. 25% “down rounds? is pretty pathetic. But when you fast-forward 1 year to 2015 5 out of 7 were down rounds. That’s 71% to spare you the math.
And one can’t properly talk about a venture outlook for 2016 without acknowledging the role that crowdsourcing of capital is starting to play in startup companies. In the past two years we’ve seen an explosion of tech-backed companies funding through crowdsourcing platforms. Readers of these pages would obviously know that AngelList is the 800-pound gorilla and the most reputable but the truth is that many new crowd-funding platforms are appearing globally and funding through such platforms has skyrocketed in just the past two years from $400 million to a whopping $2.6 billion.
Again, on the surface of things I know this sounds wonderful to entrepreneurs and of course I read all the the tropes about “how VC is dead” and is going to be replaced by a roving band of altruistic former founders sprinkling funding dust on startups. The truth is always more nuanced.
For starters the terms not being offered to entrepreneurs through convertible notes is much worse that the terms offered by seed funds & VCs who price deals and only recently have more entrepreneurs begun to speak out about this. But this is small-ball compared to the wide-scale duping of unsophisticated investors that has begun. I have warned about this publicly for years whenever asked about crowdfunding but now that abuse is becoming so transparent that I believe the SEC should begin looking more closely at crowdfunding platforms.
I have been the recipient of many solicitous emails raving about startup company performance, imploring me to “invest before I miss out,” telling investors on occasion that they can only get into deals if they also invest in that person’s fund. I have seen deals highly promoted by platforms that failed to disclose very relevant information that would have materially impacted investors’ appetites to invest.
And why not? The platforms often get paid fees. The platforms often get free carry. And what many people don’t realize is that most syndicates get what is known as “deal-by-deal” carry. What that means for investors is that if the deal you backed goes belly up (or even 49 more go belly up) that syndicate lead may still make a ton of money by deal number 50 because he or she doesn’t bear the downside costs of having lost money on his or her other losing deals. That’s why LPs don’t let VCs have deal-by-deal carry.
Importantly there will be a real cost for founders of the crowdfunding boomlet. When “every deal is a winner” and more money continues to pour in founders will benefit through downstream financings but when markets inevitably correct – who will provide all of the follow-on financings for these now stranded companies? I know that chapter hasn’t played out yet, but it will.
So my outlook for 2016?
- I suspect 2016 will be the year that the over-heated private tech markets cool but I’ve been saying that for 2 years so who the fuck knows. I do know the markets are over-valued but one individual actor can’t change market prices, which is why the Bin38 scandal was always a red herring. I will keep funding early-stage technology companies who have a vision to fundamentally change some part of an industry over a normal (8-12 year+) time horizon. There are no quick bucks in venture outside of bubbles.
- We will continue to see over-funding of late-stage venture financings until the bloom comes off the rose and then I predict rational non-VCs will return to their day jobs chasing returns in other corners of the financial world and we people who only know how to do venture will continue doing just that.
- The rise of crowd-funding as a viable alternative to VC will continue to grow unabated. Too much capital will be allocated to this channel relative to its value until the next down turn when many unsophisticated investors will be burned or until the SEC begins to crack down on the less reputable platforms or investors in these platforms. I suspect this won’t pop until after 2016 when retail investors tire of the promise of easy money in tech.
- In the meantime, the arc of technical progress will continue whatever the interim valuation scorecards of startups show. Technology continues to have profound impacts on society and industry and will continue to capture an increased portion of the total economic pie. And I suspect for the long-term venture capital will play an important role in helping support great entrepreneurs.
Note: I would like to thank my colleague Kevin Zhang for his tireless work in tracking downstream financing trends on behalf of Upfront Ventures. His work has been invaluable and perhaps if you follow him on Twitter he’ll share more insights over time.
(Cross-posted @ Both Sides of the Table)