By Paul Capon
Where is the VC environment heading and how do you avoid getting caught up in the pitfalls?
Today’s venture capital environment is more robust than ever before. Business school graduates are turning down consulting and investment banking offers from top tier firms in hopes of joining or creating the next Facebook or Uber. Hollywood is producing shows and movies like Silicon Valley and The Social Network, fueling the hype and interests of budding entrepreneurs. I greatly support the entrepreneurial spirit, and applaud folks who take a bet on themselves to create something and add value to others. I do, however, caution investors and entrepreneurs that over the next 3-5 years, returns to traditional VC’s might take a hit and access to capital will prove to be more difficult to come by. I have outlined the trends below and discussed what I believe their impact to be on the industry at large.
1) Increasing number of startups entering the scene
According to the National Venture Capital Association (NVCA), in 2009 the number of companies looking for first round institutional investment was ~1,010. In 2014 this number grew to ~1,500. While there is much debate around the cause of this growth, advances in technology, access to capital, and the millennial mindset play a big part. Today it’s easier and cheaper than ever to create your own website, market your product, and support your back end needs. Companies such as WeWork, and other co-working spaces further facilitate this growth by enabling companies to establish themselves without the traditional high cost of office space and other associated costs. Mix this with investors fighting among each other to invest and you’re off to the races. Lastly, as a millennial, many of us were told our entire lives that we could achieve anything we want, do what makes you happy and the money will follow. As the millennial generation joins the work force, their motivation and personality tend to favor the structure (or lack thereof) provided in the startup environment.
2) More capital in the VC markets
In 2003 the total venture capital investment was $19.7 Billion. In 2014, this number grew to $49.3 billion (NVCA). With interest rates at an all-time low, institutions and individuals are seeking to deploy capital in the equity markets. Additionally, to facilitate the already aggressive demand in the space, platforms such as Seed Invest, Funders Club, and Kickstarter have increased the exposure of deal flow, and greatly eased the ability to invest in start-ups as an institution, but more importantly as an individual accredited investor. The combination of the current economic environment and an increasing number of ways to invest in the VC asset class, has led to the large available pool of capital we see today.
3) Exit opportunities and numbers for VC backed companies have not grown. Leads to a surplus of companies and lower exit opportunities.
In 2010, the number of venture-backed exits were 525, and fell to 459 in 2014 (NVCA). Exits, whether it’s through the M&A market, IPO, or private buyout, are needed for funds to eventually realize a return for the later stage VC’s. For the VC industry machine to maintain its returns, the number of exit opportunities would need to increase to match the corresponding number of companies entering the pipeline. As this mismatch between entry and exit persists, a higher percentage of companies will fail to exit and as a result, lower the returns to the VC industry as whole.
Putting it all together
While we will not encounter the same losses as we did in the dot.com bubble, there will be a hit on the industry return because of this imbalance in the VC environment. Because there are more companies entering the race, and more capital justifiably or unjustifiably funding them to later rounds, fewer companies are falling out of the race when they should be. Since the number of exit opportunities hasn’t increased to meet the exit demand, a larger number of companies will reach a stage in the race where they will compete for fewer exit opportunities. Companies that are not able to exit successfully will hurt the returns for the industry as a whole. Portfolios are doing well so far because the capital available in the market enables companies to raise follow on rounds at higher valuations. I argue that many of these valuations aren’t based on the actual fundamental performance of the company, but rather based on the surplus of capital in the investor market and competition to join the deal. If the exit opportunities don’t increase to meet the next wave of companies looking to exit, I fear that the capital markets will pull back, and send a shock through the funding pipeline. Companies that were unjustifiably carried through the funding rounds will be hurt the most, along with the VC’s that backed them and LP’s will look elsewhere to deploy their capital.
How do you avoid this?
As an investor, I see a number of folks set on seeking out the next Facebook or Instagram, and investing at ridiculously high valuations that I find hard to justify. Valuations are based on over idealistic and aggressive assumptions. “If we get 100MM users we can do…XYZ”, that’s a big IF. While some companies may succeed with this model, it lends itself to an all or nothing game. Either you reach the critical mass of users to generate revenue through selling data, advertisement, or any other revenue stream associated with user numbers or you don’t. As an investor, I try not to invest in these types of companies, and tend to focus on the companies that have revenue associated with an actual product and sustainable cash flow.It’s harder for these types of companies to be overvalued, and if the capital availability dries up, companies that fall in to this category will be better positioned to continue forward.
In closing, I’m not advocating that everyone pull out of the start-up world, and predicting doom and gloom. I am just trying to highlight the trends that are materializing and providing food for thought. I do suggest that if you decide to invest, you carefully think about the types of companies you want to invest in, and highlight that the sexier, great idea (shiny object), may not be the best investment in the long run. The start-up environment is here to stay and unlike the dot.com bust, it is founded on a number of well-established companies with great business models and actual products. Just be cautious when hearing these incredible valuations and ask yourself if the company truly deserves it, or if it’s a company that should have dropped out of the race.