What’s Driving VC Firms to Take Bigger Risks

Getty Images

A flood of capital is driving up valuations for seed-stage companies, pushing even responsible-sounding venture capitalists to take bigger risks.

In his candid September investor update, Jerry Neumann of New York’s Neu Venture Capital notes that it has gotten tougher for seed-stage firms like his because startup valuations are swiftly rising, the competition is fiercer and early-stage venture-capital firms aren’t sharing as many deals.

As a result, Mr. Neumann says he eschews investments in companies where the payoff is obvious since such companies attract so much interest, prices skyrocket and potential returns plummet.

Put a whole pack of ultra-competitive type As with checkbooks into a room with a company and tell them that whoever invests wins, with the unstated but obvious caveat that whoever pays the most gets to invest, and you end up with nothing but Pyrrhic victories.

Neu, founded in 2008,  prefers to invest in companies with potential markets but an amount of risk that scares away the tourists.”

Read another way, the flood of capital is making investors take outsized risks because everyone else is fighting over the low-hanging fruit.

For the moment, the strategy can work. Neu claims an annual, internal rate or return of 65% to date. Among the company’s investments was a 2010 bet on mobile-analytics firm Flurry, which Yahoo acquired last year for more than $200 million.

But Mr. Neumann acknowledges that the flood of capital is floating lots of ships that might otherwise sink:

One thing to note is that the failure rate is much lower than plan. We expected far more companies to fail before raising a second round. This is probably mainly because we are awesome, but secondarily because it has been rather easier than it has been historically to raise equity financing.

This can’t go on forever, he says, especially with later-stage companies that are able to raise money privately. In a previous cycle, they might have to go public, imposing a level of business discipline required by the federal registration process and the prying eyes of public investors.

Companies are continuing to raise private money late in their life-cycle when in times past they would have raised public money or exited. As some Nobel Laureate said “things that can’t go on forever, won’t.” The current trend of startups neither dying nor exiting can only last until everybody on earth has their own personal startup. I expect something will break before then.

Something may break, but in the meantime, Mr. Neumann hints that he’d like to raise more capital for an “Opportunity Fund” to take advantage of later-stage investment opportunities with his own companies.

While the music is still playing, venture capitalists keep getting up to dance.