Obviously, the venture market is on fire, likely to shatter all records this year. So far nearly $239 billion (yes, with a “2” and a “b”) has been invested in 12,837 venture-backed companies in 2021. Against a backdrop which saw the U.S. Small Business Optimism index fall to its lowest level in the last six months due to spiking inflation and labor force dislocations, venture capitalists have invested at a frenetic pace and enjoyed an extraordinary exit environment.
Contributing to this paradox has been the enormous levels of government support over the last 18 months which has allocated the risks and costs of the pandemic broadly across society. The level of support provided since the start of the pandemic increased disposable household income 11% greater than the 18 months prior to the pandemic. In fact, after-tax profits generated by non-financial companies was 7% greater in the 18 months during the pandemic than the 18 months prior. This extraordinary liquidity and strong earnings environment has led to a marked acceleration in the S&P 500 EPS, further boosting investor confidence.
Data: S&P Dow Jones Indices division; Chart: Axios Visuals
The heightened venture investment activity was broad-based, impacting all stages and all sectors. While the overall number of investments continued its modest decline started six months ago, the dollars invested set another record and is now on pace to reach nearly $320 billion in 2021, which would be nearly 10x the amount invested in 2010 (yet only 3x the number of companies). According to Pitchbook (below), it certainly appears that we have entered a new “pandemic” phase of investment activity, arguably as important segments of the economy are re-architected.
There are a number of important implications that arise from this current fundraising environment. First and foremost, this frenetic pace has shown up in significantly increased pre-money valuations and round sizes. The median pre-money valuation for early stage deals was $30.0 million in 2020 but increased to $45.0 million in 2021 year-to-date. At the same time, the median round size for these companies increased from $7.0 million to $10.0 million (below). For late stage investments, the median pre-money valuations increased from $70.0 million to $120.0 million over those same time frames, while the median round size increased from $10.0 million to $16.5 million.
The tremendous number of “mega rounds” (rounds greater than $100 million) over the last three quarters clearly has skewed the data. The average pre-money valuation of late stage rounds increased from $446.2 million in 2020 to $800.3 million in 2021 year-to-date, with the average round size jumping from $37.5 million to $56.4 million. In 3Q21 alone, there were 207 “mega rounds” that totaled $49.5 billion (chart below). In other words, nearly 60% of the capital invested in 3Q21 went to only 0.6% of the companies this past quarter. As entrepreneurs weigh the benefits of raising such a large round, the level of personal dilution is balanced by the competitive differentiation such a financing is likely to create. Of course, this incremental capital also creates a burden to drive considerably more shareholder value.
This heightened level of investment has led directly to the creation of a significant number of “unicorns;” so much so that it has become somewhat passe…almost no longer remarkable. Year-to-date, 597 “unicorns” raised $136.5 billion or on average $228 million. Notwithstanding there were fewer “unicorns” in 2020 (only 333), the average round size was nearly equivalent to 2021 activity.
Number of “Unicorns”
Contributing to all of this investment activity has been the important role of non-traditional venture capital investors such as hedge funds, mutual funds, sovereign wealth funds, and strategic corporate investors. Year-to-date nearly 77% of all capital has been invested in rounds that included one of these investors. Corporate investors alone participated in 26% of all deals and those deals accounted for 51% of all capital invested. Arguably, these strategic investors are looking to access innovative solutions that may well inform their core product roadmaps, while the financial investors, in a world of nominal interest rates, are seeking greater returns above and beyond public alternatives.
And those returns have been plentiful. For 2Q21, the most recent quarter tracked by Cambridge Associates, the preliminary early stage and late stage venture returns have been 14.3% and 15.6%, respectively. Overall, the level of exit activity in 2021 has been nothing short of staggering. Exit value year-to-date is $582.5 billion, of which nearly 90% has been via public listings. Not to be lost in all of this activity is the SPAC (special purpose acquisition company) phenomenon, which has suffered somewhat over much of this year. To date, 413 SPACs have raised $109.4 billion and is estimated that there are 549 SPACs scurrying around looking for companies to acquire.
This virtuous cycle, driven by extraordinary levels of liquidity and supported by extraordinary levels of innovation, comes full circle with fundraising by venture capital firms. Pitchbook estimates that 526 funds have raised over $96 billion year-to-date for an average fund size of $195 million (while the median is only $50 million). This pace suggests that the venture capital industry will raise nearly $130 billion; ten years ago, venture capitalists raised $22.9 billion. Yet again, the average is somewhat misleading as there have been a record 19 funds raised that were greater than $1.0 billion in size coupled with a notable reduction in the number of regional and micro-funds. Another sign that there is “capital aggregation” around a more limited number of venture funds is that there may only be 150 first-time funds raised this year, which would be the lowest level since 2013. Industry analysts estimate there is now over $220 billion of “dry powder” held by venture funds.
One other indicator of industry consolidation is reflected in geographic concentration of venture capital investments. There are 24 states, nearly half, which recorded less than 50 total venture deals in 2021. Fifty deals is a mere 0.3% of all deals. Therefore, half of all states accounted for only 9% of all venture-backed companies. California alone was just under 30%. Mississippi had two companies.
When there is a correction, and there always is a correction, analysts may observe in hindsight that with flashing red lights of economic concerns, investors became complacent during the pandemic and simply invested too much, too quickly. Or some may say that the forces unleashed by Covid to restructure important sectors of the economy required the best minds to raise extraordinary amounts of capital given the enormity of the market opportunities and that these large rounds will enable the companies to power through the correction. However that plays out, it is clear that disparities are emerging: a relatively select few companies will have raised much of the capital, often times invested by a relatively select few venture firms.