Warning Signs

Written by
Ross Andrewsarrow icon

Warning Signs

Written by
Ross Andrews

So look, I’m not a market prognosticator and in full disclosure, I am a venture-backed founder so I can certainly appreciate the slight bit of hypocrisy in this post. I read a lot, especially about VC and funding markets, as a founder the state of the venture market fascinates me as the state of the industry has very real implications for founders and their startups. Today I want to walk you through so interesting trends I have been noticing lately and how some of the market indicators look eerily similar to the housing market in 07–08.

First, like the housing market, we have a two-sided market here with buyers (startups looking to secure funding) and sellers (VC funds looking to sell them capital in return for equity). Fundamentally it is the same thing as banks offering mortgages to you, me, and everyone else. Identify good potential customers and sell them a financial product that has been engineered to produce returns. Nothing wrong with that, it is part of a healthy free-market economy and when the market is operating in-balance it is a beautiful thing.

So what are the market signs that we have observed that give us a bit of cause for concern? First, in 2020 we saw a record amount of venture $ go into a surprisingly small number of rounds. Below is some data from Pitchbook that highlights this:

Now yes, with the global pandemic there is an argument to be made here that it impacted allocation strategies, but even in 2018 and 2019, venture $’s nearly doubled from their 2014–2017 ranges and yet the number of deals only increases 5–10% meaning more and more $s into fewer and fewer startups on a purely unit economic basis. There are two arguments to be made here, one bull, one bear so I am going to make both to be fair. The bullish take is that the industry is consolidating around its winners. Funds with positions in growing companies and pro-rata rights are pushing more capital into those businesses to fuel growth and eventually multiply their returns which will trickle back to LPs eventually. The bear-is outlook here is that VC funds now have greater $ exposure to a smaller number of co’s and if valuations don’t continue to increase and a certain number of companies end up failing (this would be similar to those defaults in the 08 housing collapse) the industry could be in a for a big correction.

Speaking of valuations, what has happened to valuations, specifically in the seed/series A stages over the last decade. For that, we take a look at a few great graphs from a recent post by the fabulous Tom Tunguz of Redpoint Ventures.

So seed-stage valuation have roughly tripled over the last decade.

And Series A valuations have quadrupled over that same period. Simply put, valuations have only gone up over the last decade. So what are the arguments to be made for why these valuation increases are ok versus a warning sign (again we want to be fair and present both sides of the argument)? Bulls will say it's a fair market rewarding the winners, along with the consolidation of capital into fewer winners and those winners. The bear-ish argument here is that valuations, at a certain point will need to correct. Just like with the housing market in 08, as lenders pushed into less and less qualified homeowners, things would hold up as long as home values kept rising. But if valuations flatline or even worse, drop, then the homeowner couldn’t refinance. Well in startup world, this impacts a startup's ability to continue to fundraise. Given that they are private it is hard to know exactly what the finances of many of these businesses look like but many startups are not profitable let alone break even so they are dependent on their ability to continue to fundraise at higher and higher valuations to inject operations capital into the business. If valuations correct and startups aren’t able to continue to grow and/or show profitability.

So valuations are going up and deal numbers are a big down, what’s the big deal? Well, there is a third trend that we want to highlight this morning and it is the rollback of investor-friendly terms in deals.

With record-high valuations, massive capital availability, and falling deal count numbers, investors are increasingly conceding on protective deal terms in order to remain competitive and win more deals. Now again, the bull case here, there has been push more recently for investors to offer founder for founder/company-friendly terms with many firms such as the awesome team at Pillar offering standard terms for common stock with no liquidation preferences. I am a huge proponent of this, investors getting the same class of stock as the founders and employees better aligns the two sides of this market in my opinion. But there is also the bear case to be made here and it goes in conjunction with all of the other data points we have shared above that as allocators roll back their protections, valuations soar and the total number of deals contracts, VC funds will have greater and greater exposure to relatively fewer companies that not only need greater multiples to return capital but if they fail could lead to greater exposure to the fund.

What is interesting to note here is that in 2019, the last complete year of data we could find the do this comparison, VC funds in the U.S. deployed a combined $136B in startups. For comparison, in 2019 nearly $2T of mortgages were originated in the U.S. so relatively speaking, the VC market is roughly 7% the size of the marriage market so I am in no way saying that the economy rippling impacts like in 08' is in play here. But given the power-law economics of venture investing if we do hit a tipping point there could be plenty of startups and funds that find themselves out of cash and unable to raise more.

Again, the bull case here is that in 2020 $69B of fresh dry powder was raised into VC funds meaning that there is still allocator interest in the asset class and the trends that we highlighted above are in response to what is clearly a competitive and generally bull-ish viewed asset class.

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