The Floodgates Open and the Rise of the Unicorn (2013 to 2018)
Thanks to Michael Ramos-Lynch for co-writing this series with me.
Why did seed investment explode over the last five years?
Why are there so many unicorns (companies valued over $1 billion)?
How will SoftBank return a $100 billion fund?
All that and more in this fourth post on the history of tech VC.
For context, check out our previous posts. The first one covers the early formalization of venture capital from the 1950s through the dotcom bubble. The second explores the post-dotcom era. In the third, we reviewed the split of gains from Web 2.0 and mobile by and between incumbents and upstarts. Here, we will explore the activity and changes in VC firms and companies over the past six years, setting the stage for some predictions in our next and final post.
Opening The Floodgates
By 2012, America had fully recovered from the Great Recession. Specifically, markets and financing weren’t just rebounding, they were growing anew, and dramatically. Any skepticism about the ability of Web 2.0 companies to achieve and sustain profitability had disappeared with incredible performances from companies such as LinkedIn and Facebook (9 years to IPO, profitable at IPO) and Zulily and Zynga (under 5 years to IPO, also profitable at IPO). New blue chips and behemoths like Google, Amazon, and Apple supplanted market leaders like Microsoft, IBM, and Intel to become the largest and most powerful tech companies in the world, leading the NASDAQ to outperform other major indices.
Driven by strong fundamentals, the market sentiment towards tech became increasingly favorable. These events signaled a more fundamentally sound reprise of the hype of the dotcom era, almost like a macro hype cycle for all tech.
Apple, Google, and Amazon Outpace the Major Indices
Also playing a role were unprecedentedly low interest rates and quantitative easing that followed the Great Recession. As venture investment dipped after the financial crisis in 2008, rates also (intentionally) dropped to near zero. Investment and rates quickly took on an expectedly inverse relationship, with equity investing and speculation increasing as institutional investors sought return outside low/no yield environments. The number of dollars coming into venture rose and, in turn, so did valuations.
Fred Wilson of Union Square Venture Partners noted the role of interest rates in 2014, writing: “[V]aluations are at extreme levels because you cannot get a decent return on your money doing anything else.” Additionally, investors will pay increasing premiums for growth beyond the mean, because that’s simply what the math suggests is rational. In 2015, he further asserted:
“[The valuation environment in the tech and startup sector may not change quickly. But it will change. And so will the valuation environment in the stock market. This is because valuation multiples are inversely correlated to interest rates. When rates rise, valuation multiples fall.”
We’ve watched that relationship over the past ten years, with multiples increasing to all-time highs, and now, over the past few weeks, we’ve finally started to see a reversal. More on that in Part V. For now, let’s look at the expansion at both ends of the venture market.
The Early Stage Expansion
At the early stage, angels and new funds drove a dramatic increase in new investment, with a class of seed funds firmly establishing themselves and traditional funds formalizing seed and scout investment programs.
As we wrote in Part III, the explosion of information and communities online made it easier for investors to find and track startups. The trend has only strengthened over the past six years. The continued evolution of higher level software languages and frameworks, powerful abstraction layers and APIs, and cheaper, on-demand cloud services also continued to reduce the time and cost to build a prototype or first product.
Consider the ingredients: more startups forming, more public data available about them, easier ways for investors and startups to find each other, and more money floating around. In combination, you have a perfect storm for much more “market clearing” in the early stage venture economy.
Venture Investment Reaching Doctom Levels
We can subcategorize early stage investors into three main types and consider each independently: individual or angel investors, true seed funds, and seed practices from traditional/larger funds. We covered accelerators in Part III, and you can consider them analogous to true seed funds for the purposes of this post.
Leading up to and into this time period, many early employees and investors from successful tech companies were reaping the gains of large exits. Facebook alone reportedly produced over 1,000 millionaires at IPO in 2012, similar to what happened with Google in 2004. The rebounding market brought new liquidity to previous cycles’ investors. Even employees at large public tech companies were experiencing great tailwinds as the value of their stock compensation grew by multiples. The supply of capital rose to meet existing, unfilled demand from entrepreneurs.
The opportunity in early stage investing was juicy. The Center for Venture Research estimates that angel investment increased by about ~50%, from $17 billion in 2009 to about $25 billion by 2013, a level where it remained for the next five years. Research and common sense also suggest that angel investment increases the survival rate of startups dramatically, which suggests a likely increase in activity and opportunity at later stages.
We suspect that the plateau in angel investment was driven by many individuals realizing the challenges with making their own investments, as it nearly perfectly coincides with a sharp rise in the formation of new micro funds.
At the same time, traditional funds were seeing more competition at the later stages (more on that below) and more and more companies being formed and funded at the earlier stages. To get their ownership in startups and keep their pipelines strong, many funds decided to expand downstream. It was cheaper and easier to compete with angel investors and true seed funds than newer entrants at the later stage who were less price sensitive and potentially more valuable in M&A and IPO situations. And so multi-stage brand name funds built out (big) seed practices.
Seed Investments by Accel, A16Z, Greylock, KPCB, and NEA
Of course, some trends mature and solidify, and others do not. With seed funding, the market saw a slow-down from 2015 onwards. What led to this change? The data suggest that exuberance in the seed stage ran into discipline in the Series A stage. Interest rates may have also played a role as they finally started to rise in 2015. Companies were raising too much money at too high valuations and just couldn’t make it to the next stage. As the funds were already raised by investors and had to be deployed, they began to consolidate into larger and/or later stage rounds. Notice the downward slope of the number of deals, but the fairly consistent amount of capital deployed overall from the peak in 2015 to today.
Seed and Angel Deal Volume
Number of Unique Seed Investors
In contrast to the drop in the number of rounds and investors, it appears valuations kept increasing. That may be a result of investors focusing on more developed companies and piling into them with larger rounds at higher valuations, pre-empting a Series A. Essentially seed is the new Series A, and Series A is the new Series B.
Median Pre-Money Valuation (financings under $1 million)
The above speculation is our best guess, but it’s just that, a guess. We’ve mentioned and used a number of data providers, but none is complete or comprehensive. For example, the PitchBook data above stands in stark contrast to what we estimate to be the total number of deals. The closest “source of truth” in all these matters is EDGAR (as discussed in Part III), but companies and investors don’t always make the required filings, and the SEC doesn’t seem interested in forcing the issue or market practice when there are much larger concerns for it to focus on. As a result, we suspect these numbers are even higher and perhaps seed investment was not as concentrated from 2015 to 2018 as it seems.
“Venture funds or LPs often collect their own data and create their own proprietary data sets. We at Sapphire Venture do that too, and are happy to share benchmarking analysis, best practices and other insights with the managers we work with. In addition, we also do a fair bit of research leveraging what publicly available data there is and believe others do as well too.
To further encourage the sharing of insights gained from data to help meet this interest in understanding what is going on in venture — we have done two things. First, Sapphire Ventures actively posts articles on our Medium page. Second, we helped launch, along with other LPs, OpenLP. OpenLP doesn’t collect or share open datasets but is an effort (and hashtag) to help foster greater understanding in the entrepreneur — to VC — to LP tech ecosystem.”
If we assume that dollars and deals have held constant or increased in the Series A stage and beyond, while angel and seed investment consolidated both in the number of deals and unique investors, this would suggest an opportunity for investors who focus on the earliest stages, stay disciplined on valuation, and are skilled enough to source, identify, and close on great startups pre-product market fit. And thus the market may shift back to more micro and early-stage VCs forming to fill that “pre-seed” opportunity.
Later Stage Insanity
As crazy as the seed and micro VC landscape may seem, the gigantic pools of capital entering the later stages of venture are on a whole different level. Corporations, foreign investors, and investors who more traditionally played in public markets all simultaneously moved into late stage venture investing, increasing their risk in search for returns.
Price insensitivity due to speculation and strategic aims reduced the focus on fundamentals more typically seen in later stages. Simultaneously, company management chasing all the trappings of being valued at over $1 billion. This combination ushered in the rise of the unicorn.
Again, from Beezer @ Sapphire on why companies started chasing valuations in a way they hadn’t before:
“Companies started talking about their valuations, in the past, this was not discussed so other entrepreneurs and employees knew and valued being associated with unicorns.”
The demand side of these financings doesn’t need much more explanation, but what about the supply side?
For the past several years, hedge fund and mutual fund managers have played heavily in late stage rounds. Fund managers focused on the public markets, including Fidelity, Wellington, and Blackrock, can often justy valuations other investors cannot, as they can uniquely benefit from terms related to initial public offerings and access to those offerings, and thus be willing to pay higher valuations.
Circumstantial evidence exists in how Fidelity made a number of late-stage investments only to quickly mark them down in value without material changes or significant time passing. The only change was which valuation methodology was being applied, the company’s or Fidelity’s public market comparable.
The number of investments by these players peaked in 2015, as did the number of seed rounds, which, again, is when interest rates finally began to rise again.
Large corporations also got heavier into the late-stage venture game during this time period. Note the shift towards larger investments and rounds in the later years of this period:
Corporate Venture Activity, Deal Volume and Deal Size
Similar to public fund managers, corporate investors’ interests beyond the financial return from a current round of financing can also drive up valuations. A great example is Intel’s recent investment in Cloudera. In February of 2014, T. Rowe Price and others invested in Cloudera at a valuation of $1.85 billion. In May of 2014, just three months later, Intel invested in Cloudera at a valuation of $4.3 billion, or 2.3x higher. By late 2016 and early 2017, shares of the company were trading at half the valuation Intel paid. When the company finally went public in April of 2017, the valuation was about the same, causing a 50% or so public markdown of Intel’s investment.
Based on the above, did Intel make a bad investment? If we’re only measuring the direct investment return, absolutely. However, Intel was well aware of how much substantially higher a valuation it was agreeing to, and reportedly Intel and CloudEra were partnering to develop products that ensured both of their continued growth with enterprise customers. Intel may be about $300 million or more underwater on its investment, but if the value gained by its business units is greater than that amount, perhaps it was still a ‘good’ investment after all.
Similarly, the valuation data echos the point on the impact of corporate venture:
Median Pre-Money Valuations in $ Millions
In addition to public market investors and corporates, foreign investors also brought capital to the late stage markets, including sovereign wealth funds. Many were looking outside their own low rate and/or unstable markets, also seeking better returns. Often facing strong competition and seeking footholds in a new market, such investors may be more willing to invest in higher valuations.
Chinese Investment in US Tech
This cavalcade of capital into later stage technology companies has several consequences.
First, more late stage companies will face difficulty in future financing, taking investment at lower valuations. Less commonly and more devastatingly, they may shut down entirely. We’re already seeing this happen as per the above example. According to CB Insights, as of October 2018 there are 131 unicorns in the US, of which 42 have had a subsequent financing event or exit at a lower valuation in the last four years. More capital for investors means more pressure to deploy and less ability to maintain lower valuations. Inflated valuations and inflated expectations feed on each other. At the earlier stages, the impact can be missed as the market is already heavily skewed and unpredictable. However, more capital at later stages leads to more competitors at later stages, which leads to more losses and volatility than would otherwise expected.
Second, as companies stay private longer and avoid public markets, early employees and investors will demand liquidity. The more robust liquidity-providing solutions become, via companies like Equidate and EquityZen, the longer and more easily companies can stay private. And so a vicious/virtuous cycle is born.
Together, these two forces increase volatility and restrain the IPO pipeline, as fewer companies need to IPO and fewer are ready to IPO. In the dotcom era, the average company age at IPO was about five years; it’s since doubled to over ten years.
While late stage investment appears to have leveled off over the last few years, expectations are rising. SoftBank has a monstrous $100 billion Vision Fund and is planning another already. Sequoia Capital announced a $8 billion late stage fund that is in no way a reaction to SoftBank. This drives a belief that the public markets may continue to be denied access to return on investment provided by the great, new technology companies, and that the overall market may see a depression in returns as competition increases.
With an explosion of early-stage funds and massive amounts of capital waiting in the later stages, one might expect investment to continue at high levels and valuation at all stages. However, if interest rates have taught us anything, investment and valuations decreases as they increase. Add in the crypto and ICO market and the future is incredibly uncertain. More on all of that in our next and last installment, where we’ll explore the forces defining the future and try to project how it may look.
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Neil Devani is an early stage investor based in San Francisco, California working with companies that create positive externalities, with a focus on the healthcare, financial services, and education sectors as well as certain frontier technologies. He is also a licensed attorney in the state of California. Find him on Twitter, AngelList, or LinkedIn.
Michael Ramos-Lynch previously worked for a venture firm in Palo Alto, California and is currently an entrepreneur and practicing attorney in Austin, Texas. Find him on Twitter, AngelList, or LinkedIn.
None of the above post is intended as investment or legal advice.