I’ve heard many people in the VC space talk a lot about the market, ranging from investors talking about how difficult it is to find quality deals, to entrepreneurs complaining about the lack of investor appetite for high risk, high return ventures. To be fair, this is highly variable by market, as anecdotal evidence suggests that some markets (e.g. China) are more resilient to macro economic pressures than others (e.g. Korea), but I digress.
A good benchmark I’ve always relied on is the good old USA. I’ve always found the US to be the benchmark when it comes to the finance industry, for better or for worse, with many other markets playing catchup in the following months. For example, a big buzzword in the VC industry the past year was AI, particularly machine learning, with a focus on autonomous vehicles, and natural speech recognition. But this was a trend that was already growing in the previous years in the US, particularly in Silicon Valley.
But that’s just one example. Another example is a loss in investor appetite for see stage and early stage ventures. This is another trend that was an ongoing problem in the US, but is becoming a growing problem globally. This is the main focal point of this retrospective, to see where the money is headed, and what problems may arise for both investors and entrepreneurs.
Just a disclaimer, I’ve used data from PitchBook for this piece, rather exclusively, as it was the most comprehensive data set I could find for this sort of data. Understandably, such a reliance on a single source comes with its own inherent risks, so reader discretion is advised.
Year Over Year
Truth be told, this year wasn’t a terrible year for the market, overall. The overall deal volume was higher than in the past decade, rising 12% year over year. The trouble is in the number of deals closed. That’s fallen to just over 7,700, or down 10.68% year over year. That’s in addition to the 17.6% drop YoY in 2016.
Average deal volumes, based on these metrics, are $7.6M in 2015, $8.4M in 2016, and $10.5M in 2017. Bear in mind that these numbers are not outside the norm when you consider the average Series A round size in Silicon Valley, but it is an alarming growth rate. This continued upwards trend will, no doubt, push for higher valuations, and may be indicative of a bubble.
Then, there’s the opposite argument, of how normal this is, considering the latest US CPI sits at 2.2%, which is in line with the Fed’s goals. This is to say, you can expect good economic times for the US market in general. Moreover, this year saw a slew of deals from giants like Softbank, which could have skewed deal values to the larger side.
This may also be more of a symptom than a root problem, as more and more companies are staying private for longer, opting for additional venture financing, even debt financing, before going public. But, with players like Social Capital looking to set up an alternative investment vehicle for startups looking for public financing, we might see this not be a problem at all. With more and more startups looking for ways to become liquid, without going public, we might see the rise of an alternative market altogether.
Quarter Over Quarter
This is a rather bad metric to go off of, especially because there’s no real seasonality to the VC market, but it’s interesting to compare individual quarters between years. The biggest surprise, to me, was that Q3, and Q4 2017 saw huge spikes YoY. But the number of deals closed actually took a pretty big hit. What’s worse is the main culprit for this drop seems to be the Angel/Seed investors.
What this means, I’m not sure, but it probably means one of two things. Either, A. Investors can’t invest as they have their capital held up in unicorns that are reluctant to exit via an IPO, or B. Investors are looking for alternative investment assets. Both of these have equally plausible explanations.
Uber is a great example of scenario A. In fact, up until this round with Softbank, investors couldn’t actually liquidate their holdings with the company. This is still the case with many other unicorns in the industry. Scenario B is where things get interesting.
2017, we saw record years for all major indices in the US. This, compounded with the relative liquidity crisis the VC market is facing today, may push investors to look at the public markets for returns. Many could have the expectation that, if they play their cards right, they’ll be able to make at least half the return, with a fraction of the risk associated with traditional VC funds. Combine this with rising base rates from the Fed, and traditional investment vehicles look like a great alternative for investors.
Big VC firms may not feel the pressure, as much, since they tend to be just a part of the portfolio for other funds, and high net worth individuals, especially when compared to Angels or seed round funds, which may comprise a sizable amount of a person’s investment assets. This could also explain the YoY increase in deal sizes, but the overall decrease in number of deals.
Here’s a good rule of thumb — if you don’t hear of a big profile IPO or acquisition in the news, then there’s probably not many exits in that year. That’s mainly because IPOs cost a lot. In order to make it worthwhile, they need to make sure everyone is aware it’s happening.
But, this year, it just wasn’t the case.
In fact, of the largest exits this year by Bay Area VC firms, Snap Inc. was the only IPO. And, it was the only exit that was highly publicized. Not many people knew Roku also had their IPO, nor can people recall the big acquisition of AppDynamics by Cisco for nearly double AppDynamic’s IPO.
The point is, many companies that are household names, like Uber, Lyft, AirBnB, even Palantir, and WeWork, are private entities. Yet, their valuation exceeds AppDynamic by quite a margin. You can see a full list of unicorns here.
The problem is this lack of exits will, inevitably, affect the whole VC market, halting the flow of capital. Hopefully, Uber does go public in 2019, as per its plan. And, hopefully, that sets off the domino for many other unicorns to find ways of making their shares more liquid.
Time to Exit
This graph is to reaffirm a point I kept making throughout this piece. The secondary buyout line can be ignored, as I don’t think it’s an exit that most investors have in mind when investing in a startup. The interesting line is the IPO line. But, let’s start off with the acquisition line.
The time to exit via an acquisition now stands at 4.78 years. But the shape of the line is interesting. In 2013, it dips to below 4 years, and then continues upwards, back up to 2012 levels. This could be indicative of a lack of interest in younger startups by potential acquirers, or it could be indicative of startups unwilling to sell out earlier. Either way, the trend isn’t too volatile. It’s rather stable, and in line with anecdotal expectations of around 4 to 5 years.
The IPO line is volatile, and it’s trending upwards. This is much less a lack of appetite for IPOs. In fact, most public investors are eager to explore new companies, especially those with big VC funds backing their names. The problem is, startups are unwilling to take the plunge. This article from Yahoo Finance is a good introductory course on the matter, but the TL;DR version is, essentially, that you can have longer term goals as a private company than you can as a public one.
Now, whether that’s a good thing for investors in the startup is another question. But it’s definitely a problem when it comes to the market as a whole. Liquidity is everything when it comes to investing, and this definitely isn’t helping it. In fact, it’s one of the largest obstacles keeping people away from VC investing. Despite its lucrative returns, VC remains a niche because people hear stories of their money being locked up in these companies for years at a time.
The upwards pressure on valuation isn’t of much help either, as staying private has proven to be more lucrative than going public for many companies. Blue Apron’s valuation dropped to a third of its IPO, while Uber is still valued at $48B, despite its recent PR scandals, and its own profitability problems.
If Uber was a public company, it’s questionable whether it’d be able to uphold its valuation. But, because it’s private, it’s proven to be more resilient than a holiday fruit cake.
There’s no way for a person to accurately predict the future, so I’ll refrain from doing such a thing. I will, however, list out 3 things I hope come true for the new year.
First, more companies should make an exit. Though no one speaks of it, there’s a strange tension from VC funds concerning their liquidity. You feel it when you go into a VC meeting. They’re more cautious than ever, especially because so much of their fund is locked up in a startup that’s unwilling to exit. If that situation isn’t alleviated soon, we might actually have a bubble on our hands.
Second, more institutions need to make smaller, seed round focused funds. I say this because the bulk of the problems that arise from the aforementioned liquidity crisis impacts these seed stage startups the most. There are highly promising startups, that I’ve met personally, who are finding it more difficult to raise than ever before. These are serial entrepreneurs, too, who have the connections necessary, and yet can’t seem to raise a round.
Third, alternative exit options to the IPO and acquisitions must exist. I’m saying this because the two are, rather, restrictive. An acquisition can take control away from the founder, changing the identity of the company, while and IPO can do similar damage by way of focusing management efforts on short term profitability. In order to increase liquidity in the market, we need more exits, but the argument for long term philosophy can’t be ignored. Hopefully the SPAC (special purpose acquisition vehicle) experiment by Social Capital works, and proves to be a good middle ground, and a great third option.
But, overall, 2018 should be an interesting year, especially considering the bullish forecasts for the public markets. It’ll be interesting to see whether startups take advantage of this to push for more IPO exits, or they wait it out to avoid another disaster like Blue Apron.