Social Capital’s Chamath Palihapitiya demonstrated dramatic flair in October when he labeled venture capital a “bizarre Ponzi balloon” and vowed to sit on the sidelines.
Palihapitiya, in truth, may not be the one to offer the industry a didactic scolding, having witnessed the near disintegration of his firm. But he has a point.
A deluge of capital washing over growth-stage and even early-stage companies has greatly inflated prices and pushed customer-acquisition costs higher. The consequence is that returns could be harder to earn for early-stage LPs and others in the startup ecosystem.
“One would think that investors should become more circumspect about the utility of their capital during times like these,” Palihapitiya asserted in an annual letter laying out his argument.
They haven’t. Now add a dash of business-cycle worry to the recipe and the taste is far worse for VCs, LPs and founders.
No one can predict whether or when the cycle will shift and how deep a slump might be. But so far, few investors seem to take the possibility seriously, especially at a time when a structural imbalance floods the business with capital.
“I think we’re closer to the top of the market than not,” said Tim Guleri, a managing director at Sierra Ventures. “Having a conservative stance is probably the responsible thing to do as an investor.”
It isn’t hard to make such a case. The Nasdaq is up 450 percent from its 2009 lows and the BVP Nasdaq Emerging Cloud Index, as of mid-November, was ahead more than 300 percent from 2013.
Venture investing is likely to hit an 18-year peak this year with more than $100 billion dispersed. And fundraising could set a similar record, with more than $32 billion raised through the third quarter, even with a slowing of foreign money from China and elsewhere due to trade and other tensions.
Unicorn financings are on a tear, as are $100-million-plus deals in general.
All this comes at a time when the financial markets are beginning to look choppy and the IPO window, which had opened nicely to permit 52 deals on U.S. markets through the third quarter, looks to be shutting, at least slightly.
Still, predicting the course of economy is a fool’s errand. There is scant evidence on the economic horizon to suggest a shift in business activity. Unemployment is low, economic growth is strong, business metrics at many startups are good and interest rates remain relatively low, if rising in measured steps.
The recent third quarter saw a fall off in business investment and weakened exports, probably due to the simmering trade war with China and the waning impact of the Republican tax cuts, but not enough to dangerously rock the boat just yet.
“I don’t see a downturn,” said Donald Dixon, a managing director at ForgePoint Capital. “I don’t see a bear market. I see a correction in a bull market.”
Still, being prepared is part of the game.
One key question is what kind of downturn a turn in business conditions would resemble? For one, the money in megafunds, particularly SoftBank’s Vision Fund, could serve to prolong an up market in venture capital, even if the U.S. economy starts to weaken.
Clearly some of the froth would leave the market, and with it many of the fat checks for growth companies. This would hit unicorn companies the hardest and make cash on hand a far greater predictor of survival. It also would focus new attention on burn rate, and could cut revenue multiples in half.
Money would simultaneously tighten for earlier companies, slowing their growth at a critical stage of their development. Less cash as well would likely flow from corporates and crossover investors.
For some thoughtful investors, preparing is already part of their strategies. This includes in some cases shifting investments earlier and making fewer high-priced late-stage bets, or even bets on oversized A rounds.
“We’re seeing lots of good healthy companies with good trajectories and very profitable returns on their sales and marketing activities,” said Ethan Kurzweil, referring to later-stage deals he’s seen as a partner at Bessemer Venture Partners. “We’re still seeing opportunities in the market, even at the prices of today.”
“But because everything is priced to perfection, we’re being very selective,” Kurzweil said.
Another outgrowth is accelerated fundraising. Firms have begun coming back for new funds ahead of schedule. And with solid distributions so far this year, LPs have the cash to invest.
“Many people are preparing by raising capital so they have capital if the market changes in the next year or so,” said Kirsten Morin, co-head of global venture capital at Aberdeen Standard Investments.
For new funds, the calculus is a bit different. New York-based Humbition announced in October a $30 million early-stage fund with four deals completed.
“We think it’s the best time to start a fund,” said Managing Partner Cyrus Massoumi, founder and the former CEO of Zocdoc. “We don’t have to worry about our Series C and Series D companies and what will happen to them.”
One investor who has taken additional steps is Guleri. Sierra Ventures has allocated capital to what is in effect a rainy-day account. That means earmarking $25 million of the firm’s present $171 million 2016 fund to support portfolio companies in the event of a slowdown.
This extra support is on top of normal reserves. Plans are to do the same and set aside 10 percent of the next fund, which Sierra will begin to raise in the next six months.
Yet few investors appear to have slowed the deployment of their present funds. Instead, they say a consistent pace of investment remains their strategy.
After all, the 2008 and 2009 recession might have seemed a risky time to put out capital, but the period coincided with the rise of mobile and the development of companies such as Twitter.
“Our communication with our LPs is market volatility represents an opportunity,” said Jeff Richards, a managing partner at GGV Capital. “A lot of people run for the hills. We are very consistent in our investing.”
But some say flexibility also is key to their plans.
If a downturn sets in, ForgePoint will consider going later stage to find better values, Dixon said. The firm focuses on Series A and B, but in a downturn could turn to growth-equity deals.
“We will slide up and down the maturity scale of companies depending on the valuations,” Dixon said. That will lead to “less technology risk.”
Downturns also bring the opportunity for portfolio companies to upgrade teams and make acqui-hires, he noted.
But he isn’t ready to jump the gun.
If a downturn comes, “we’ll cut the burn rates for our own companies,” he said. “We won’t be slow to do that.”
Well-capitalized companies also can take advantage of a downturn to make acquisitions when target valuations are down.
“In a way, downturns are healthy,” said Jules Maltz, a general partner at IVP. “They reveal what companies are truly the best businesses and which entrepreneurs are truly committed to their businesses in any market condition. It washes out the irresponsible businesses.”
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