In the last several weeks I have spent a lot of time thinking about the current environment of the venture capital industry. At a high level it may seem like an inefficient market because the flow of information is quasi-directional and there are only a handful of firms capable of tracking it. Be that as it may, those of us who rely on this information understand that even though it’s not totally perfect it is still highly useful understanding trends and key issues that exist in the industry.
If I had to choose two issues that I think are top of mind for those within the VC industry they would be 1). Company Exits and 2). Valuations. Let’s talk first about Exits. There are a handful of ways a company can exit and provide cash to its investors: Be acquired and merge with another company, sell itself outright, liquidate and shutdown, secondary sell of company stock, or sell company stock to the public. There are probably other ways, but I think you get the point.
Achieving a profitable exit is (or should be) every investors objective. I am sometimes bothered when I hear investors say they hope a venture-backed company never goes public. When a venture-backed firm goes public it is often the most profitable path to exit for early investors. Recently, Ken Langone stated in an interview with CNBC that he hopes Palantir never goes public. Mr. Langone is an investment banker known for helping to secure the initial financing Home Depot needed for expansion in the early 80’s and he is also a multi-billionaire. I understand why he doesn’t care if Palantir doesn’t go public, but I’m sure many other investors think differently.
Twenty years ago, the average time it took for a company to go from first initial investment to eventual exit was roughly four to six years. Now, that can take anywhere from eight to nine years (sometimes longer). There are several reasons behind why the timeframe to exit has been lengthened, but I won’t mention them all in this post because I feel like that’s been heavily discussed for several years now. However, if you are interested in digging deeper, take a look at this article from Pitchbook on this topic.
The other concern on investors’ minds right now are private company valuations. Valuations for later stage companies are at record levels and I’m not sure if it will level off any time soon. According to Pitchbook, “the most significant increase in valuations has occurred at the late stage, where the median pre-money valuation as of 1Q 2018 pushed to $75 million, a 19% increase from 2017.”
For anyone who has taken an economics course the one fundamental takeaway every student must know is the law of supply and demand. Right now, there is an oversupply of capital in the venture market and not enough deals. One question we could ask is whether having an oversupply of capital could be a good thing for entrepreneurs. Should an oversupply of capital be a signal to would-be entrepreneurs to get off the sidelines and create something spectacular? Is now a good time to start a company because investors are flush with cash and the chances of getting funded are probabilistically better? Maybe, maybe not. Valuations haven’t substantially increased for seed stage companies and even though there’s an abundance of capital in the market investors remain careful with how and where they invest.
This gradual shift in investor preference for later stage companies over the last decade could suggest that investors are becoming increasingly more conservative. While investing in some later-stage companies still classifies as ‘venture capital,’ there is exponentially less risk involved. This by no means implies that for an investment to be classified as a venture capital investment a substantial level of risk must be taken. What it does reveal is that later stage investors are hoping for significant gains on the upside while attempting to minimize risk on the downside.
I spoke with one venture capitalists who plainly told me that if someone is going to invest $10 million or more into a single company that person shouldn’t have to worry about losing their entire investment. While it is somewhat reassuring to hear someone state this belief, it is impossible to know whether or not that will happen with 100% certainty.
One of my favorite sayings is “a rising tide lifts all boats.” And given that we’ve been in a bull market for the last 10 years it’s been somewhat difficult to determine which boats will continue to rise once the tide goes out. At this point, all we can do is wait and see. Cheers – KM