The venture capital sector is heading back to Earth. The big question for the new year is how bumpy its landing might be.
A new set of data indicate that key segments in venture capital — the business of funding startup companies — will be down sharply for 2015, a sign that the dramatic run-up in startup valuations is peaking and the funding of new ones is tapering off.
“There are a lot of indicators that we’ve reached the peak of the VC investment cycle,” said Daniel Cook, an analyst at New York research firm PitchBook Data Inc.
The number of “first financings,” the very first round of professional funding for nascent startups beyond money from family or friends, stood at only 1,983 financing deals as of Dec. 1, compared with 3,368 for full-year 2014, according to PitchBook. The total dollar amount for first financings figures to be flat or down: $6.91 billion recorded through Dec. 1 compared with $7.5 billion last year.
Meanwhile, money reaped through so-called exits — via the sale of startups to another company or through an initial public offering of stock — is projected to end the year off dramatically: about $64 billion on 860 deals compared with $93.77 billion on 994 deals in 2014, according to a Pitchbook analysis.
The drop in first financing “indicates that the future crop of VC-backed companies will be weaker than we’re used to seeing,” Cook said. Plus, he said, “Exits are down dramatically, and the public markets are in limbo.”
Demand for VC funds, however, continues strong, with investors pouring in nearly $37 billion so far this year, up from $34 billion in 2014, to get a slice of later-stage startups such as Uber and Snapchat.
Still, the slowdown for the youngest companies and waning exits indicate a general cooling, analysts said. Among the causes: the lackluster performance of major public stock markets, which provide a guidepost for valuations and an important market for venture capital firms to sell their holdings and exit their positions. Meanwhile, fundamentals in technology, a key sector among VC firms, are weakening.
John Lonski, chief economist for Moody’s Analytics, said revenue for software and services was down 2.4 percent in the third quarter from the year-earlier quarter while even once-booming tech hardware saw sales rise only 3.6 percent. “Those numbers are not exactly barnburners,” he said.
Investors are pulling back on riskier investments across the financial spectrum, Lonski said, noting that borrowers in the high-yield corporate bond market, often seen as a proxy for venture capital and other risky markets, have been forced to pay ever-higher interest rates in recent months.
Meanwhile, the IPO market in general has hit the skids. The value of deals in the economy was just $36 billion through Dec. 10, compared with $95 billion for all of 2014, according to the research firm Dealogic.
Other cautionary signals for the VC sector, analysts say, are recent IPOs that saw highly touted startups trade at lower-than-expected valuations. San Francisco-based payments company Square Inc., for instance, was priced at $9 a share at its November launch, lower than the expected range of up to $13. And while the shares did shoot up 45 percent to $13.07 in the first day of trading, they had drifted down to $12.65 as of Wednesday.
Steven N. Kaplan, a finance professor at the University of Chicago, said 2014 and 2015 marked a “frothy” period of startup valuations that was bound to taper off. He said the rapid rise in the number of startups valued at $1 billion or more, known as unicorns, is coming to an end for the time being.
“A little bit of the luster has come off a lot of the unicorns,” Kaplan said. “A lot of them have had trouble maintaining their values.”
Some observers see a softening in the VC sector as posing risks to future innovation.
“It’s certainly on the decline, and it’s a not-so virtuous cycle,” Mark Cuban, the owner of the Dallas Mavericks who made his fortune in the dot-com era with broadcast.com, said in an email interview. “Fewer exits mean less money to invest in new deals.”
But while most observers take a cautious approach to the sector for now, few foresee a calamitous decline approaching the dot-com crash of 2000. Pitchbook’s Cook, for instance, says it’s more likely that the sector will slip back 2013 levels, when VC firms raised about $24 billion from investors compared with the $37 billion expected to be raised this year.
And some say it’s still too early even to call a peak in the VC cycle. A report by PriceWaterhouse Coopers and the National Venture Capital Association notes that the $47.2 billion invested by VC firms in startups in the first three quarters of 2015 was higher than the full-year totals for 17 of the last 20 years, indicating continued momentum heading into the current quarter. What’s more, the report notes 1,070 individual funding deals recorded in the third quarter, although 11 percent below the second-quarter figure, is roughly in line with the number of deals per quarter going back to 2011.
Tom Ciccolella, who heads PriceWaterhouseCoopers’ U.S. venture capital market group, also noted that the overwhelming majority of the largest VC deals of all time, including those raising $1 billion, were done in 2014 and 2015.
“I don’t know if we’re in the sixth inning or the third or there are two outs in the bottom of the ninth,” he said.
Predictions about the sector are particularly difficult these days, analysts say, because the VC sector rarely held on to startups once they were valued at billions or even tens of billions of dollars. Snapchat Inc. in Venice and Uber Technologies Inc. in San Francisco fit that category.
The sector has crossed into a new era in which companies grow to maturity in the private markets and achieve levels of revenue growth, and in some cases, profitability, not seen in the dot-com era. As a result, any funding or exit slowdown is far less threatening, analysts and observers say, because many startups have the wherewithal to continue to grow on their own.
“It’s a paradigm shift in the way these companies are financing themselves,” said Bill Siegel, head of Nasdaq Private Market, a unit of Nasdaq Inc. that helps large privately held companies manage their shares. “It’s the new normal.”
Still, even those who believe that it’s too soon to call a peak say a cautious approach to the sector is in order.
“We all know we’re in uncharted, unprecedented territory,” PriceWaterhouseCoopers’ Ciccolella said, recalling the dot-com crash. “It’s good to keep an eye on it because of where we’ve been.”
(Source: Tribune Content Agency, LLC.)