Earlier today I tweeted:
Calling #PeakVC. Right here, right now. Done.
— Manu Kumar (@ManuKumar) October 13, 2015
But I realized shortly after tweeting this that there is so much nuance packed into that one term #PeakVC that it requires a lot more than 140 characters.
So here are some of the things I was thinking about when I tweeted this:
Peak Oil is defined as the point in time when the maximum rate of extraction of petroleum is reached, after which the rate of production is expected to enter terminal decline. It doesn’t matter whether you believe in the Peak Oil theory or not. I’m simply borrowing the term to coin #PeakVC. I define #PeakVC as the point in time when the maximum amount of $$s are entering the Venture Capital industry. There are simply too many LPs stuffing the VC goose! There are new accelerators, new VC funds, SPVs and more popping up left, right, and center.
Unlike Peak Oil, which will probably occur once in our lifetimes (next time it happens perhaps we will be the oil!), #PeakVC will happen many times in our lifetime. That is because the venture capital industry operates in cycles. When the perception of returns in the venture capital industry goes up (for examples when new paper unicorns are being minted every other day) then everyone and their mother feels like they should be investing in venture capital.
That increases the overall money supply coming in to venture. Most recently the influx that been from what I like to call non-traditional sources of capital. This includes, but is not limited to money from China, India, Middle-East and also from “retail” investors (or otherwise unsophisticated investors who are attracted to a market simply because of the amount of press/media attention it gets).
The catch however, is that venture capital does not scale linearly with the amount of capital entering the industry. In fact, quite to the contrary, if the amount of capital entering the venture capital space as a whole increases, the overall returns from the industry as a whole are likely to decline. This is because as more capital enters the market that means that more $$s are chasing the same high quality companies. That increases the competition for deals and drives up the prices (valuation) of these deals.
A lot of people ask me what’ the difference whether you invest at $3M premoney or $6 premoney? (Examples are tailored to the stage at which I/K9 play, but there is no difference even if you add a couple of zeros to those numbers). Well the difference is that by doubling the entry valuation you half your return multiple. A 20x return becomes a 10x return and a 1x return could easily become a 0.5x return.
As valuations increase, VC returns go down. Not to mention that in later stages, high valuations can almost be fatal for some companies that don’t have the operating metrics to justify those valuations once the market turns.
I’ve often said in private that I blame LPs for the cyclical nature of the venture industry. As other asset classes become less interesting than venture capital, they start to direct more dollars into venture capital. That in turn causes the venture industry returns to stumble, which in turns leads LPs to pull back out of venture. As the money leaves venture, companies are forced to build real businesses instead of living a venture-subsidized existence and the returns for the industry improve. And then the cycle repeats itself.
The catch this time around is that the increase in venture capital dollars is coming from “new LPs.” And some of these new LPs will be very fickle and will run out of the market just as quickly as they’ve come in. In fact, one big jolt to the eco-system and I wouldn’t be surprised if you start to see “new LPs” reneging on their capital commitments to new funds.
The traditional LPs who have been in this business for a long time know that they have to stay in the market in order to see returns as the best investments will often happen in down markets. The sad part however is that they have little control over the overall money flowing into venture and therefore are susceptible to the cycles. It’s tough job… I don’t envy the LPs who have to make calls in such situations.
What does all this mean for founders? Well, if we’re at #PeakVC, that means that there is more money in the system right now than ever before. The cycle that leads to the decline of the venture capital returns takes time as the dollars flow through the system. So in the near future, it’s likely that more companies will still be able to raise capital. This is probably especially true of the early stage (pre-seed and seed) stages of financing since so much of the “new LP” money coming into the system is directed at these stages of companies.
This means more noise in the system for seed stage investors. More companies get funded at the early stages. Middle stage (Series A/Series B) investors will get to pick the best companies from an increased supply of companies to look at. However, the competition for these companies will also be intense.
Over time, I expect to see a lot more pre-seed and seed stage companies that are unable to raise follow-on financing. I wouldn’t call this one a Series A Crunch, as that was a misnomer to begin with. Instead, I’d call it a Seed Explosion.
I don’t claim to have a crystal ball to see how this will all play out. But if we are at #PeakVC as I suspect we are based on the ridiculous amounts of dollars flooding in to the VC ecosystem, then there’s only one way things could head from there.
If you’re a founder, make hay while the sun shines. Raise as much capital as you can, but watch your burn rate like a hawk. You may need that capital to last a while.
If you’re a new GP, chose your LPs wisely (if you have the luxury to of course). Long-term, patient capital is what you want to be able to build a franchise.
If you’re a sophisticated LP, you already know that the industry operates in cycles and you have to maintain consistency through good times and bad.
So that’s what I was thinking when I tweeted #PeakVC. Yup, it was a loaded tweet.
Update 10/13/2015 4:25 PM: Mark Suster and Chris Dovous both pointed out to me that it is unfair for me to blame the cyclical nature solely on LPs and they are correct. GPs and founders are just as guilty for raising bigger and bigger funds and for raising massive financing rounds respectively.