Indicator Insights: VC Market Dynamics
Recently there’s been a lot of talk about what’s going on in venture. The talk is largely being driven by concerns for what some see as potentially unsustainable growth – growth both in terms of fund sizes but also in terms of valuations, and capital raised. According to Pitchbook, “maybe more than ever before, the first half of 2018 embodied the high level of capital availability throughout the US venture industry. $57.5 billion was invested across 4,000 deals, pacing the year to surpass 2017’s decade-high total for capital invested by the end of next quarter.” Ultimately, this translates to concerns that this kind of growth leads to companies being overvalued and overcapitalized (2018 deal value has already surpassed 6 of the past 10 years).
At Indicator Ventures, we agree that there are many overvalued and/or overcapitalized companies in today’s market. We can talk about why that’s the case, but simply put we believe it’s a result of VC funds raising more capital, growing larger with each fund, and in turn, having to deploy more capital. This not only creates more competition and drives up valuations, but with more capital to deploy there’s also more capital to return. Therefore, companies are raising more money and staying private longer.
While we don’t proclaim to be immune to macro environments, we do feel that our practical approach helps us mitigate some of the risks associated with broader market conditions. Our primary filter of “digital efficiencies” is the first step in helping to add downside protection. Quite simply, any product (or service) that generates massive cost or time savings will in turn have significant inherent value. This means that we spend less time trying to figure out if a product will be valuable (product-market fit risk) and instead focus more on operating the business (execution risk). Generally speaking it also means less time to commercialization, AKA generating meaningful revenues. We also skew more towards capital efficient businesses. The less money a company requires to grow, the less money they need to raise and the lower their bar for optimal returns on exit. We also like to invest in companies that are revenue-generating. It sounds like an obvious thing, but a lot of VC investors aren’t as concerned with revenues as they are with the larger vision, especially at the early stage. The more revenues a company generates the easier it is for them to manage overhead, and ultimately generate realized value. Lastly, we also look for and favor companies that can exit earlier in their life cycle (3-5 years). Starting companies is a hard thing to do (~70% of all start-ups fail on average 20 months after raising a seed round). Selling a company is even harder (of ~35k companies started from 1990 – 2010, 80% failed to achieve an exit). That’s why it’s important for us to invest in companies that can sell, even if it’s a ‘smaller’ exit. Realizations (and returning LP capital) are considered king and that’s what we optimize for, (in our first fund we sold 5 companies in the first 4 years of the fund life).
Larger VCs don’t care about the smaller exits. They have too much capital to return which means the smaller exits don’t move the dial for them. Meanwhile, the smaller exits are naturally the most common. According to industry data, over 80% of acquisitions of venture-backed companies happen below $200M. The other 20% of exits are above $200M but that band shrinks quickly. Less than 1% of all venture-backed companies that exit achieve “unicorn” status ($1B+ valuation). So, statistically speaking we have much greater odds of success by focusing on companies that can sell in the $200M band; and to be abundantly clear, this does NOT mean that our upside is capped at $200M (4 of our companies are already valued north of $200M today) it simply means that we can generate outsized returns within this band. Assuming we stay true to our mandate and guidelines, remain disciplined about entry valuations and that our companies are efficient and don’t raise significant amounts of capital at unreasonable valuations, we can deliver fantastic fund-level returns. This works because our fund is sized appropriately to achieve best-in-class returns from seed stage investing. And that’s really the key here; fund size. While we’ve only been at this for several years (as institutional investors) we can’t envision raising a fund of more than $100M and still being able to produce consistent, risk-adjusted returns.
In closing, we’re not saying that larger VCs such as Sequoia, Accel, A16Z, Kleiner Perkins, etc. are wrong. Instead what we’re saying is that we take a different approach, and we believe that our approach is not only a better way to realize high upside while mitigating some risk, but it’s also a better way to protect from broader market conditions like overvaluation and overcapitalization.
Oh and I’d be remiss if I didn’t call out two people that I respect for validating some of these thoughts in recent conversations. Big thanks to Sarah Anderson and Nick Faulkner at Cintrifuse for offering their thoughts and feedback on our model. Cintrifuse is an incredible Fund of Funds and we share a lot of the same beliefs in terms of the need to build companies that offer real value as well as the need for funds to focus on returning capital. I’d also like to thank Micah Rosenbloom at Founder Collective for similar validation. If there is one fund that I’d say we truly look up to and would like to replicate, Founder Collective is certainly at the top of that list (BTW – their most recent fund was $75M, following their previous fund of $75M – these guys get it when it comes to optimal fund size).