Venture capital firms and early-stage companies could see a major fall in their fortunes soon. A combination of a vicious cycle of inflated valuations, unsophisticated financial models, and lack of investor perspective has led to an unsustainable bubble in the start-up sector and the firms that fund it.
Karam Hinduja is the Founder and CEO of Timeless Media and Karma, a digital platform that curates leading alternative investment perspectives. As a spokesperson for impact investment and innovation in the media industry, Karam provides us with detailed insight into the venture capital bubble.
The venture capital industry has ballooned over the past decade. Recent research has found that the size of the sector has effectively tripled in just ten years: in 2008, $53 billion worth of capital was invested in startups, but by last year the figure was $160 billion. Over that time, deal count has more than doubled.
More than $130 billion worth of financing found its way to some 8,400 U.S. companies last year, a record which even beats the capital invested in 2000, in the heady days of the dot-com age. 256 American venture funds closed last year having secured almost $56 billion from limited partners. Meanwhile, 2018 saw numbers both of so-called “mega deals” (those worth more than $100 million) and of investments into unicorn companies almost double on the year before, according to estimates from the National Venture Capital Association. 2019 may be another big one for exits, given IPOs lined up for unicorns.
Just as the industry has grown in size over the past 10 years, so has it increased in attractiveness. Venture capital has become sexy—drawing more and more budding investors to the space, in the hopes of being able to find and fund the next Facebook.
But a damaging result of the industry’s newfound sex appeal is that unsophisticated investors, thinking that they can play the game, have now begun to position themselves as venture capitalists. They think that they are funding exciting businesses—but they are in fact often chasing ideas. Great minds may have generated great concepts or even great products, but these may not always translate into sound businesses.
Such thinking has led to huge bubbles and valuations that are, ultimately, unjustifiable. Investor disquiet at Softbank's Vision fund—which was recently reported to be buying stakes in companies with inflated valuations—has shone a spotlight on the issue. But valuations are often not determined based on a hard view of a company’s real revenue and earnings. According to recent estimates from the National Bureau of Economic Research, unicorns are, on average, about 50 percent overvalued.
The circle of tech founders and venture capital firms, meanwhile, has become an echo chamber, one fueling the other with claims that they have found the next big thing. Of the $130 billion invested last year, a full $100 billion went towards technology. Advanced robotics or artificial intelligence may certainly make great headlines, but proper financial models rarely factor into the equation—indeed, an unsophisticated investor probably could not even read one.
This crucial lack of understanding has contributed to a toxic cycle in venture capital. Venture capitalists get on board at valuation X, and then attempt to jack up the perceived value of the company to X+10 for the next investor so that the first investor can make a return.
The founders and CEOs of the companies play into this. Instead of building sound businesses, they focus on “positioning” their companies for the next funding round—effectively, playing branding and marketing roles in order to court the next group of investors, or to get bought by a bigger firm, instead of properly managing their revenues, costs, and operations.
The investors in VC funds are not helping. They often do no diligence on these funds at all. They seem quite happy to sit back and invest in funds that have a “spray and pray” model—those that invest in 60 companies and hope that one or two turn out to be the next unicorn.
There is too little focus on identifying and nurturing the robust, financially dependable businesses which should be at the heart of a stable economy.
By definition, venture capital is of course about betting on early concepts. But there is surely a line between the core aim of the industry—to place strategic, informed bets on businesses with foreseeable growth potential—and what is actually going on in the industry today. It is ultimately unsustainable. Without a change soon, we could see the bubble burst.
So what can bring venture capital back on track? First, we need a change of mindset from founders and investors, who must fundamentally understand that there is a difference between a product or concept, and a business. They should ensure that the companies they are buying into offer a sound business case, rather than just ideas and soundbites. VCs should also foster the business acumen to help founders build businesses around their ideas and products.
Veteran Silicon Valley tech entrepreneur and Stanford and Columbia academic Steve Blank has probably summed up the current environment best: “VCs won't simply admit that they're in a giant Ponzi Scheme. They have to play along, because they've taken money from their investors, and their investors expect a certain return, but it's no longer an honest game.” Without facing up to this reality, and acknowledging its flaws, we risk revisiting the dot-com bubble.
Second, we need stakeholders to be aware of the risks should momentum start to fall off in the market. Greg Becker, the CEO of Silicon Valley Bank, has warned that should we see “investors switch sentiment from ‘greed’ to ‘fear’” then “many growth stories priced for future perfection” may find themselves in trouble. Without a proven ability to generate revenue, more startups will find it harder to attract capital once over-valued companies are exposed, and the “grow fast” strategy adopted by many investors and venture capital firms runs out of steam.
We cannot let the unfounded ambitions of unsophisticated investors to continue fueling the money-driven echo chambers. At the end of the day, it is only the well-intentioned, if naive young founders—some of whom should never be CEOs in the first place—who will suffer. We owe it to the next generation of budding entrepreneurs and business owners to give them enough structure and a dose of reality.
This article is presented by T1.