Ups and Downs in the Venture Capital Market

Twenty Years of Ups and Downs in the Venture Capital Market _ Part 1

The U.S. Congress recently marked the 10th anniversary of the JOBS (Jumpstart Our Business Startups) Act, a package of bills intended to reinvigorate a slumping, post-financial crisis economy. Initial Public Offerings (IPOs) were way off their 1990s highs, a fact that some critics blamed on regulatory overreach in the form of the Sarbanes-Oxley Act (SOX) of 2002. (Two financial crises in one decade didn’t help either.)

With the JOBS Act ten years back in the rearview mirror, and SOX another ten years, it’s a good time to look back and take a long view of the venture capital market that is so critical for financing innovation and entrepreneurship. Some argue that the current VC market is robust. But that old model of funding innovation isn’t always up to the task. We need a new model.

The Booming Nineties… And Then a Reality Check

Many startups go through several rounds of VC funding before they are in a good position to go public - a move that provides additional operating capital, and a way to pay off investors. So Initial Public Offering (IPO) activity can be a good measure of the health of the venture capital market.

IPOs started ramping up in the 1980s, and really hit their stride during the 1990s. Although the number of IPOs peaked in 1996 at 709 (A total of 739 U.S. firms raised $43 billion, surpassing the 682 IPOs and $39.6 billion raised in what had been the previous record year, 1993[1]); although in Europe, the number of IPOs peaked in 2000 hitting an all-time high of 843[2], the entire era of the dot.com bubble (1995 to March of 2000) was good for IPOs.

But that doesn’t mean it was necessarily a golden era in terms of innovation and real value. The year the number of IPOs peaked was the same year that former Chair of the Fed Alan Greenspan famously coined the phrase “irrational exuberance” to describe the speculative bubble that occurs when the market becomes overvalued and starts to believe its own hype. The editors of Bloomberg remind us[3] that, amidst all of this exuberance, a number of “poorly conceived” companies (like Pets.com) came to market, and that we shouldn’t get too nostalgic over the sheer volume of IPOs in that era.

A New Normal

The JOBS Act has helped… somewhat. Several bill’s provisions targeted smaller startups it designated as Emerging Growth Companies. Since 2013, 93% of U.S. IPOs were completed by EGCs. A recent Congressional report concluded the bill has made a “significant difference” in the ability of young, high-growth companies to raise capital.

But overall IPO numbers remained stuck in that two-decade plateau — one which may be part of a “new normal” for IPOs. Part of that new normal is that, while deal count and volume have only increased modestly, average and cumulative deal valuations have grown considerably. More money is being concentrated in fewer deals. The greatest growth in the past decade has been in deals of $10 billion or more, while the number of deals under $100 million has shrunk.

Valuations skyrocketed for big major classes: Equity (represented below by the SP500, the mainstream benchmark for US Equity.)[4] and M&A.

Valuations skyrocketed for big major classes: Equity and M&A

This new normal seems to apply to the VC market as well. And not just in the U.S., in Europe too:

Starting in 2008, the Fed launched four rounds of QE (quantitative easing), over six years adding almost $4 trillion to the money supply. A bond-buying program during the pandemic pumped more money into the system during the pandemic. Similarly, in Europe, the central bank’s Asset Purchase Program initiated in 2015 flooded European markets with cash. The ECB followed up with the Pandemic Emergency Purchase Program in 2020.

Since 2008, the Fed launched four rounds of quantitative easing

In both the U.S. and European markets, central bank stimulus programs intended to counter the effects of the 2008 crisis (and later, the pandemic slowdown) flooded the market with cash. As the supply of venture capital swelled, investors had to compete with each other, increasing the negotiation power of venture firms, and pushing valuations up.

Other factors were certainly at play as well. Investors outside the traditional VC eco-system started exploring venture capital as a potentially lucrative asset class and making their own direct investments. Valuations soared accordingly, with much of the total volume concentrated in a handful of deals.

The VC Market Is Back… Or Is It?

The tepid growth in IPOs (until the last two years, that is) notwithstanding, the last decade has been a robust one for venture capital deals. The USVC index 10-year IRR (Internal Rate of Return) stands at 18.7%. The last two years have been especially impressive. Even IPOs have (for the moment anyway) made a comeback.

Venture capital deals began gathering steam in the mid-2010s. In 2020, U.S. VC-backed companies raised a record $166.6 billion — . That record was shattered as total deals almost doubled in 2021, hitting $329.1 billion. The numbers are down so far in 2022, the opening quarter showing a 19% decline. But that really only reflects the historic nature of last year’s numbers; Q1 ’22 is still the fourth biggest quarter ever.

IPOs also surged. 2020’s 431 was more than double the previous year. And 2021’s 951 broke the earlier record year of 1996. Many of these were of the SPAC (Special Acquisition Company) variety, which accounted for more than half of all IPOs in 2020, and almost two-thirds in 2021. SPACs are technically a kind merger (even more technically, a reverse merger) in which a shell company is formed with the intent to acquire a yet-to-be-determined target.

So, all is well, right? Not so fast, as someone once said. While an article last year by Cambridge Associates boasts[5] that “Venture Capital Will Continue to Crush It,” the late 1990s are a sobering reminder that gaudy numbers do not necessarily reflect real value. Even as SPAC IPOs were soaring, some warned[6] of a “SPAC bubble.” And close analysis[7] of the numbers revealed a pattern of high dilution and poor post-merger performance. By the end of 2021, it seemed clear that the SPAC bubble was collapsing, as a number of high-profile (and highly-hyped) deals were cancelled. “To put it simply,” says Jay Ritter, a professor at the University of Florida who specializes in IPOs, “there’s too much money chasing deals.” In January of this year, TechCrunch declared the SPAC boom a “failure.”

The excess hype and inflated valuations that set up the SPAC boom for inevitable failure are not, I am afraid, specific to SPACs — but instead indicative of problems in the venture capital market in general. I have worried for some time about the larger pattern of more capital being concentrated in fewer deals. In 2020, mega-rounds (deals of $100 million or more) accounted for half of all VC funding. Late-stage deals drove two-thirds of all deal value. Early-stage seed rounds were down to 400 a quarter (in 2015 that figure was 610). First-time financing was up sharply in 2021, but mega-deals still dominated the landscape. And the number of unicorn births (startups with a valuation of a $1 billion or more) broke the century mark of 100+ for three straight quarters.

Central bank policy in the U.S. and in Europe flushed capital markets with surplus cash looking for deals and produced a temporary boom in VC activity. But this is not a sustainable model. We need less chasing for deals, and more digging for value. One encouraging sign is the growth in other exit strategies like trade sale. Established companies, knowing they cannot innovate with the speed and agility of start-ups, are increasingly looking to invest in or acquire start-ups as an alternative to in-house innovation.

Innovation can be defined as a series of waves when the accumulation and rate of change combine to produce an exponential effect. The modern market economy is technology-based, adaptive, evolutive, and innovative. At its leading edge, the sixth wave of computing, embodied by, artificial intelligence and ambient, intelligent, and sentient exponential technologies, promises unimaginable breakthroughs in science and engineering, and solutions to many of our most difficult problems. The sixth wave will yield more innovation and impact than any force in history. For venture investors, it will be the stuff of dreams.

History is written by the victors, while no one was looking. New winners emerge in each new innovation wave. The sixth wave is an infinitely complicated, entangled system that blurs the lines between the physical, digital, and biological. Complexity is the primary challenge, and VC must evolve to meet it. Policymakers, investors, and business leaders need data-driven decision-support systems to decode the complexity, to predict the future, and target their innovation programs and funds at the technologies that will deliver maximum impact and ROI.

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