The Bureau of Economic Analysis recently announced that the real Gross Domestic Product increased at a 3.5% annual rate in 3Q18, which while lower than the 4.2% reading in 2Q18, continued a streak of six quarters above 2.0%. Notwithstanding strong economic fundamentals, there appears to be evidence that the sugar high provided by the corporate tax cut may wearing off as 35% of the S&P 500 companies missed 3Q18 Wall Street revenue estimates according to FactSet. Year-over-year revenue growth estimates for the S&P 500 is 7.3% although for fiscal 2019, revenue growth estimates have been lowered from 8.2% to 5.4%. According to Evercore ISI, 3Q18 year-over-year corporate earnings will have increased 24% but 13% of that is attributed to the tax cuts, while 11% is organic growth. This broad reset, alongside raising interest rates, are in large measure responsible for the marked increase in public market volatility over the past month.
None of this appears to have rankled the venture capital industry. With great fanfare, and a tinge of trepidation, the National Venture Capital Association recently announced that venture investors invested $27.9 billion in 1,937 companies in 3Q18. The venture industry is on pace to exceed $100 billion invested this year. The average size of investment at $14.4 million, although somewhat meaningless given the range of activity covered, is the largest average round size ever which reveals an important concentration of capital around fewer portfolio companies. Over 24% of all investments in 3Q18 were in late stage companies, which is the highest proportion in seven years. In fact, nearly 29% of the capital invested in 3Q18 was in just 39 unicorn companies. There were 51 financings that were greater than $100 million in size and those captured 64% of the capital invested in 3Q18.
This concentration of capital is also echoed by the continued rotation away from seed and angel investing witnessed in 3Q18, which saw only $1.6 billion invested in 785 companies which was dramatically lower than the $2.1 billion and 1,005 companies in the prior quarter. Seed and angel investments were 5.6% of all dollars invested and 40.5% of all companies in 3Q18. The average round size was $2.0 million, which is significantly greater than every prior quarter (save for 2Q18 when it was $2.1 million). Over 56% of all seed rounds were greater than $1.0 million. The implication is that seed rounds are no longer simply to “prove out an investment thesis” but rather to start to scale start-ups. Another interpretation may be that a level of risk aversion has entered the marketplace, causing timorous venture capitalists to focus on more mature later stage companies.
The early stage sector also saw a marked increase in round size to $12.9 million across the 686 companies. Interestingly, the median deal size was $7.0 million which is twice as large as early stage financings in 2014. Nearly 59% of early stage capital was invested in round sizes greater than $25.0 million. Year-to-date there have been 378 financings that were larger than $50.0 million. These large financings turn the historic definition of early stage milestones on its head and presumably are providing companies with extended runways. Another possible explanation may be due to the dramatic increase in fund sizes as investors look to “put more to work” in any one portfolio company.
Where it gets really interesting is in the late stage category. Quite clearly, we are in an “anoint the winner” cycle of investing with a dramatic increase in average round size of $37.4 million; over the past 10 years, the average round size was $19.0 million for late stage financings. In 3Q18, while over $17.4 billion was invested in 466 late stage companies, 51 of those financings were greater than $100 million in size and accounted for $11.0 billion or 39% of the entire quarter’s activity. That is right – less than 3% of all companies accounted for 39% of the dollars invested this past quarter.
This stepped-up investment activity is also reflected in quite robust pre-money valuations. Across each stage, valuations were at high water marks, most notably in the Series D and later stages at $285.0 million (year-to-date), which is effectively twice what it was just two years ago. Year-to-date, average round sizes for early stage and late stage companies were $14.1 million and $36.4 million, respectively, which compares favorably to the pre-money valuations (perhaps suggesting more modest dilution than in prior periods).
There was one other development that was quite noteworthy and that involved the corporate venture investors. Notwithstanding some notable recent announcements of retrenchment (Intel Capital, the most prolific corporate VC, let go 25% of its investment staff this week), corporate investors participated in $39.3 billion worth of financings through 3Q18, which is already greater than any prior full-year period and represents nearly 47% of all deal values. Ten years ago, corporate investors consistently participated in less than $10.0 billion of annual financings.
Liquidity and generating superior returns drives the venture capital industry. The exit environment in 3Q18 remained strong with 23 venture-backed IPOs (17 of which were biotech companies). Additionally, a handful of very late stage companies “nominally” went public, selling a very small portion of stock suggesting that the IPO was less of a financing event but rather to provide founder liquidity. There were 182 venture-backed exits for $20.9 billion in 3Q18. For the year-to-date, there have been 637 exits for $80.4 billion (which coincidentally mirrors closely the $84.3 billion that has been invested year-to-date). Arguably a more relevant barometer as to the health of the venture market is how many new companies are being funded versus being sold; that ratio has been above 10:1 since 2013 (save for 2014 when it was 9.6:1) which reflects the reality that companies are staying private longer and that consistent investor liquidity is still somewhat elusive.
Cambridge Associates (CA) data highlight the strong venture capital returns which outperform broader public equity indices in nearly all timeframes. Specifically, for year-to-date, 1-year, 5-year and 10-year periods net returns for the CA Venture Capital Index (2Q18) and the S&P 500 Index are 11.7%, 20.1%, 17.4%, and 10.9% versus 2.7%, 14.4%, 13.4%, and 10.2%, respectively. The comparisons are likely even more attractive given the public market turbulence this month. The ever-important distributions back to limited partners increased 17% to $21.5 billion in 2017 over 2016 levels and are expected to be strong again in 2018.
All of this has clearly benefited fundraising, although similar to the dynamics many entrepreneurs are facing (fewer but larger financings), the venture industry continues to be barbell – small handful of large venture funds alongside numerous smaller focused funds. Year-to date the venture industry has seen 230 new funds close on $32.4 billion with median fund size of $68 million and the average fund size of $151 million (the highest level since 2011). In 3Q18, venture capitalists raised $12.2 billion; the top ten largest funds accounted for $8.2 billion of that total (or in other words, just ten funds in 3Q18 represented over 25% of all capital raised so far in 2018). Twelve of the largest 25 funds raised in 3Q18 were based in San Francisco and 7 were in Asia.
The healthcare technology sector was white hot in 3Q18. Both Rock Health and MobiHealthNews reported that $3.3 billion was invested in 71 companies this past quarter – the best quarter ever. Year-to-date there have been 290 financings totaling $6.8 billion, which is tracking to make 2018 the most active year yet and likely to be between 8-10% of all venture capital activity (this was low single digit percentage points a decade ago) suggesting that this sector is reaching a level of maturity. In 2011, there was $1.2 billion invested in 93 companies. The chart below from Cooley points to the number of significant companies now scaling to provide enterprise solutions.
Domestic spending on healthcare is over $3.2 trillion. As a point of comparison, the U.S. advertising industry is estimated to be $190 billion and launched thousands of valuable start-ups over the last 20 years. This augurs for even better times ahead as new revenue and risks are reapportioned across the healthcare industry. The FDA is playing a particularly supportive role, in large part through Commissioner Gottlieb’s pre-certification program which has seen 34 FDA approvals or clearances in this sector so far in 2018. Notably, there have been a series of significant strategic partnerships announced such as GSK’s $300 million investment in 23andMe.
According to Statista, there will be 5.8 billion smartphones globally by 2020 and over six million apps across various app stores. The Institute for Human Data Sciences at IQVIA estimates that 318,000 of these apps are healthcare specific, and most have never been tested much less widely utilized. This harkens back to the Dot.com phase nearly 20 years ago when thousands of content and commerce companies were launched, many of which struggled to create enduring economic value. The enormity of the healthcare industry suggests profoundly important healthcare technology companies will emerge, but more often than not, they will need to offer comprehensive end-to-end solutions which both lower costs and improve outcomes.
On the Flying Bridge 