Who thought that it could get any better? After nearly $83 billion of venture capital was invested in 2017, this past year clocked in at nearly $131 billion; in fact, 4Q18 registered $41.8 billion or nearly half of all of 2017 activity, according to National Venture Capital Association and PitchBook data. The level of activity was unprecedented and has left some industry observers somewhat befuddled as to the current state of the venture capital industry.
As always, the headlines risk obfuscating a number of significant trends and themes. Notwithstanding that the amount invested in 4Q18 was $10 billion more than just the immediate prior quarter, nearly 10% fewer companies were financed (2,071 in 4Q18 vs. 2,282 in 3Q18), further underscoring the recurring theme of capital concentration with fewer companies raising disproportionately larger rounds. Across the board, average deal size was markedly greater in 2018 than for any of the last dozen years (for later stage deals, average round size of $43.8 million was nearly 3x that of 2007).
Driving this concentration of capital is the proliferation of very large later stage rounds, most notably the $12.8 billion investment in Juul. In 2018, there were 198 financings greater than $100 million in size and they totaled $61.1 billion (2.2% of all deals in 2018 accounted for 46.7% of the dollars invested). In fact, over 61% of all financings were greater than $25 million in size. At the end of 2018, there were 120 unicorns parading around (CB Insights counts 315!). The underlying reasons for this phenomenon likely reflect the investment activities of some relative newcomers such as SoftBank’s nearly $100 billion Vision Fund (more on that later) as well as attractive (i.e., elevated) private market valuations, certainly as compared to public market valuations. With the explosion of the amount of venture capital looking to be invested, it is not surprising that round sizes have so dramatically increased as have later stage valuations, hitting $325 million in 2018 (up from $137 million in 2016).
At its essence, the debate about company valuation turns on ownership levels. Advanced-HR recently published fascinating ownership data which concluded that for post-Series A companies over the last eight years, investors owned 45.4%, founders held 35.6%, and employees were granted 16.6% of the equity, typically in options. This is even more interesting in light of the chart above which suggests that early stage venture-backed companies will have raised on average about $17 million.
Whether this level of activity is good or bad is difficult to determine. The venture capital industry has a chronic problem of “capital absorption” – too much capital, too quickly undoubtedly leads to considerable and widespread heartache. While there has been a five-year steady decline in the number of angel/seed stage financings, early and later stage investment activity have remained relatively constant with between 700 – 800 early stage and 450 – 550 later stage companies funded quarterly, suggesting that there has not (yet) been a “crowding out” effect.
One other potential explanation is that these enormous financings are meant to finance companies to the point of being self-sustaining (free cash flow positive) and not ever have to rely on public markets to raise additional capital. Arguably, many of these later stage companies can now address global markets which both requires significant additional capital but also offers a path to build much larger businesses.
Industry analysts are quite focused on the impact of SoftBank’s Vision Fund. At the end of 2018, $45.2 billion of the fund had already been invested in just 18 months according to Dow Jones (perhaps overstated due to the transfer of some large assets into the fund upon formation). This level of activity is unprecedented in the venture industry, both in terms of size and pace from one investor. It underscores another important development involving corporate venture capital entities; nearly 51% of all financings in 2018 had at least one corporate investor in the syndicate. Not surprisingly, most of this activity was in later stage deals. Corporate investors tend to be less valuation sensitive as they are also solving for a range of strategic issues.
The Vision Fund has also triggered an arms race among some of the larger venture capital franchises, most notably with Sequoia’s recent $8.0 billion new fund which closed in 3Q18. For all of 2018, $55.5 billion was raised by 256 funds, signaling strong continued limited partner interest in the asset class. The amount raised in 2018 was nearly 5x the amount raised in 2009 during the depth of the Great Recession. While the average fund size of $226 million is not that informative (median was $82 million), it is instructive that 11 funds larger than $1.0 billion were raised in 2018, again pointing to further capital concentration among investment managers (43% of all capital raised in 2018 went to these 11 firms). Importantly, first-time funds were quite well-received having raised $5.3 billion across 52 funds, both amounts significantly ahead of any year in the last dozen years.
Much of this limited partner interest in the venture capital asset class stems directly from the encouraging signs of consistent and meaningful investor liquidity. For all of 2018, there were 864 exit events, although the activity in 4Q18 was the lowest level in the prior 27 quarters. Of that activity, 604 of those were M&A transactions valued at $54.4 billion in aggregate, on average nearly 4.8 years after initial funding with a median valuation of $105 million. Unfortunately, this may be tricky for some companies as post-Series D average valuations in 2018 were $325 million.
There were 85 venture-backed IPOs in 2018 raising $63.6 billion in proceeds, 22 of which were valued north of $1.0 billion. This arguably overstates how robust the exit market really is; the average time for a venture-backed company to get public in 2018 was 12.6 years. Cleary IPO activity is a terrific proxy for the health of public capital markets, but they are financing events and only put a company on a path to generate future venture investor liquidity.
Notwithstanding approximately $75 billion of “dry powder” (capital raised but not yet committed), it is somewhat precarious to contemplate the amount of invested capital in aggregate that would need to be supported should conditions meaningfully deteriorate. Venture capitalists are forever struggling with the “sunk cost” dilemma of investing good money after bad. If a particular portfolio company is struggling, at what point does the investor stop supporting it or look to sell? It is quite common for early stage investors to reserve $2 – $4 for every dollar initially invested. Strikingly, the Silicon Valley Venture Capitalist Confidence Index fell to 3.2 (out of 5.0) in 4Q18, which is notably down from 3.5 in 3Q18 and is the lowest point since the Great Recession. Interestingly, the discount in the secondary market for venture capital partnership interests increased from 20% in 3Q17 to 25% in 3Q18 according to Setter Capital.
FactSet recently reported that analyst estimates for 1Q19 S&P 500 corporate earnings were revised downward to a 1.9% decline, which was a dramatic revision from the 7.0% increase expected in September 2018 for 1Q19 earnings. While the calculus is complicated, and undoubtedly clouded by the government shutdown and trade tensions, a deceleration in corporate earnings will both impact general investor sentiment and public equities. In point of fact, according to Morningstar, in December 2018 a staggering record $143 billion of capital rotated out of actively managed investment funds into passive vehicles in the United States. The impact of these capital flows on the IPO market is likely not helpful.
While perhaps foreboding, the story in China may also be quite revealing. Stock performance for all of 2018 in China was very poor, with major stock indices in Shanghai and Shenzhen showing losses of approximately 25%. According to Wind data, 395 public companies on those two exchanges will generate cumulative operating losses between $43 – $50 billion for 2018, which will be the worst performance in a decade. Concomitantly, Chinese venture firms raised $44.8 billion which was down 13% from 2017 levels, according to Zero2IPO. The number of investments dropped 10% to 4,321. The South China Morning Post just announced that venture deal activity declined 60% in January alone. There are estimated to be 186 unicorns in China, with 100 having been created in 2018 alone (although only 11 in 4Q18). And there were only 24 Chinese technology IPOs in 2018, suggesting there are now a number of nervous VCs there.
Against all of this venture capital data, the World Inequity Database released other data pointing to perhaps even more disturbing areas of capital concentration. The top 400 citizens in the United States have a combined net worth that equals the bottom 60% (~150 million people). According to Axios, at the end of 2018 there were 2,208 American billionaires. Globally, the 26 most wealthy people posses the same wealth as 50% of the world’s population according to Oxfam. Staggering.