Start-up Investments Boom While Silicon Valley VCs Turn Cautious

by the Curmudgeon




The venture capital industry is booming, but for how long?  Institutional investors, including investment banks, hedge and mutual funds have joined the party which is still going strong.


VC backed global companies raked in $32.5B in the 2nd quarter, spread across 1,819 deals.  That's according to the inaugural edition Venture Pulse report by KPMG International and CB Insights.  


The Q2 VC investment data is as follows:

Total Global Data: $32.5B in funding | 1819 deals


VC Investments by Market Sector:


Internet and Mobile software continue to account for the bulk of deals to VC-backed companies, as the two major sectors accounted for 65% of all deals in Q2’15.  Mobile enjoyed significant jumps in Q4’14 and Q1’15 investments, riding on the large rounds to Snapchat and on-demand ride sharing companies like Uber and Didi Kuaidi. Are those really tech companies?


So far in 2015, Internet investment share has increased such that it accounts for more than half of total investment dollars into VC-backed companies in 2nd  quarter of 2015.


All other sectors remained fairly range-bound with Healthcare accounting for 12%, Software 5%, and Consumer Products & Services 3%.


The U.S. VC Environment:


U.S. funding is on track for a stunning $70B year: After a high of $56.4B in 2014, 2015 is on track to reach five-year highs with $36.9B already invested in the first half of the year.


California dominates VC investments in start-ups. While deal activity in California has slowed down for the last few quarters, deals continue to top 400 per quarter, more than Massachusetts and New York combined!


Six mega-rounds account for one-fifth of all North American funding: These deals were all $275M or larger, including a $1.5B growth equity round to AirBnB. Q2’15 also saw four exits larger than $1B.

However, U.S. deal flow shows some signs of fatigue: 


The Rise of the Unicorns & Late Stage Deals:


It's been a banner year for Unicorns – VC backed companies with valuations in excess of $1 billion. The 2nd quarter of 2015 saw 24 new billion-dollar companies compared to just 9 in the same quarter a year prior.  Those include 12 in the U.S. and 9 in Asia. Among the newest Unicorns were Zenefits, Oscar Health Insurance and MarkLogic.



The explosive growth of Unicorns is being spurred by the continued availability of late-stage deals – in particular, new capital sources including hedge funds, mutual funds and sovereign wealth funds. More on this later in the article.


The availability of late-stage mega-deals continues to delay potential IPO exits.  During Q2-2015, global late-stage deal size averaged $72.6 million and included more than thirty $100M+ deals globally.


If companies can raise similar amounts of money through private financing, many companies will opt for it. Under private financing agreements, companies have more latitude to grow and shape their business and can avoid more substantive public reporting requirements. Going public comes with a strategic decision making process that can be far more complex and highly driven by shareholders.


Looking forward, indicators prompt the report authors to suggest that Unicorn investing will only continue to rise as more and more investors chase these opportunities.


-->There is real fear among many institutional investors that they will be left out if they don’t have a number of unicorns in their portfolio. That's even if the unicorns they're investing in have indicated they don't plan to turn a profit for years, if ever!  Many are 1 trick ponies, which we discussed in the post titled:  In Search of Unicorns and One-Trick Ponies: Bubble in Private Tech Start-Ups   


Confidence of Silicon Valley’s VC's Hits 2 Year Low:


With all the excitement and big bucks going into so many unproved start-ups, VCs have turned more cautious. Venture Beat reports: 

“Amid the frenzied fund-raising and soaring valuations for startups, Silicon Valley’s venture capital community is starting to get a little bummed out.”


For the second straight quarter, the Silicon Valley Venture Capitalist Confidence Index fell, hitting its lowest point in two years. The index, measured by the University of San Francisco School of Management, has fallen four of the past five quarters.   


The survey is in its 11th year and includes feedback from well-known valley VCs such as Tim Draper of DFJ, Venky Ganesan of Menlo Ventures and Shomit Ghose of Onset Ventures.


The 28 VCs surveyed reported a confidence level of 3.73 on a 5-point scale, down from 3.81 in the 1st quarter. The survey asks VCs to rate their confidence in the high-growth venture investing market over the next six to 18 months.


The waning confidence was attributed to increasing concerns about the high valuations of startups, a surge of investing from hedge funds and big institutional investors (e.g. Goldman Sachs, Fidelity, TRowe Price, Black Rock, etc.) that is driving up funding rounds, the rising cost of doing business in Silicon Valley and potential fallout of global economic issues like the free falling stock market in China.


"The unprecedented fundraising and valuations associated with so-called 'unicorns' ... gives reason for substantial pause," said Bob Ackerman, founder and managing director of Allegis Capital. "Expectations are beginning to outpace reality."


Mark Cannice, Professor of Entrepreneurship & Innovation at USF, conducts the research study each quarter.  He said VCs expect overall conditions for IPOs and acquisitions to remain strong.  "As VC confidence tends to be forward-looking, this disparity is not unusual," Cannice wrote in the report. But, he added, “Increasing concern about high valuations of venture-backed firms restrained sentiment.”


Risks of Mutual/Hedge Fund Investments in Start-Ups


Many believe that public market investors (like hedge/mutual funds or investment banks) are taking on too much risk when they invest in private companies, the majority of which fail and return nothing to investors (i.e. 100% loss). 


In our opinion, a bigger risk is to the start-ups themselves, because there’s a big difference in the way that investments from VC firms and public funds are structured.  The former are illiquid, while the latter have either monthly (hedge funds) or daily (mutual funds) liquidity via redemptions.


During the dot-com crash 15 years ago, “many hedge and mutual funds faced massive redemptions when the market cratered and they had to find a way out of their [private company] positions,” said Glenn Solomon, a partner with the venture firm GGV Capital.


That fire sale caused a secondary market for venture positions tied to those fund positions to spring up, and the shares were often sold at a deep discount -- driving down the overall value of the start-ups.


“It was tough on management teams, which were often facing challenges in their companies, to all of a sudden face shareholder pressure, too,” Solomon said.


We saw a similar and dangerous mismatch between long-term investments and short-term funding during the 2008-2009 financial crisis.  Many financial service companies, including investment banks, bond insurers, General Electric, AIG, etc. took short-term money and invested it in securities that turned out to be risky and illiquid.  The same thing could happen again with start-up investments, particularly by paying a higher price in late stage rounds.


“Founders should ask questions about the objectives and intentions of their potential investors and also about the source of and permanency of the capital being provided,” Solomon said. If they don’t have a clear sense of what they’re agreeing to when they take money from public investors, they could get burned.


Of course, the biggest risk, is that most of these now high flying start-ups will fail and go belly up.  That's exactly what happened during the DOT com bust and telecom/fiber optic buildout crash.  Every month we see one or more of such hot companies that seem to be pie in the sky.  Let's look at one of them, appropriately named Inc.


Despite steep losses and looming competition with, online retailer (AKA Jet) is in talks for capital infusion that could value the company at $3 billion!


A July 19, 2015 WSJ article states: 


“Online marketplace Inc. has almost no revenue, years of likely losses in its future and a strategy that includes underpricing mighty Inc. on millions of items. Jet also has perhaps the highest valuation ever among e-commerce startups before their official launch.”


“That is no contradiction in Silicon Valley, where investors keep pouring money into audacious business experiments filled with big-splash potential. Jet is the buzziest e-commerce arrival of the current boom, with $225 million in capital raised in the past year.”


On July 29th, the NY Times chimed in with their own assessment of Jet and similar e-commerce start-ups: 


“On a venture-capital high, tech start-ups are burning through vast cash reserves to offer rock-bottom prices, and to sign up new customers with discounts, giveaways and other deals that may sound too good to be true. Jet, a Costco-like members-only discount company that has raised more than $225 million from investors before opening its doors, is only the largest such example.”


Marc Lore, Jet’s chief executive, predicts that it will take the company five years to grow to a point where it is not losing money on every shipment — a threshold it says it will cross once it has signed up about 15 million members and is selling about $20 billion in goods annually.


The NY Times reporter found that Jet was vastly undercutting Amazon, and The Wall Street Journal recently ordered a basket of goods from the site for which it calculated that Jet lost nearly $243 on a single order. In an interview, Mr. Lore was unfazed by these numbers, because, he said, they were already built into his projections.


Good luck to Jet and to all readers of this column!


The Curmudgeon


Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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