A Deep Dive into What Has Really Changed in Venture Capital

This post is by Mark Suster from Both Sides of the Table - Medium

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I’ve heard a lot of people question whether there is too much money in venture capital chasing too few great deals. “We’re in a new tech bubble!” some have pronounced. “Valuations are out of control” is the mantra of others. Others believe that new business models are emerging that could replace venture capital all together.

Every year I try to answer the question of “what has changed in the Venture Capital industry” and this year my colleague Chang Xu and I took a deep dive through the data and called many of our peers for confirmation. If you want the whole deck you can find it on SlideShare but I’ve written up a short summary with commentary below.

1. Yes, VC / Startup Funding is up Massively

If you look at how much VC firms have raised from Limited Partners (LPs) over the past 2 decades you’ll see that we’ve returned to a level that we haven’t seen since 1999. That’s a reason why some are quick to portend “a new bubble” but this post sets out to show that would be a misunderstanding of the market and in fact by historic levels this may be amongst the best times to invest in seed and early-stage funds. More on that later.

By any objective measure the amount of money going into tech-enabled startups is up considerably (left chart) while the amount of money that VC funds have raised from LPs is also up significantly (right chart).

2. But the Majority of the Dollar Increases Have Been in “Mega Rounds”

If you look one layer deeper at what has happened in the Venture Capital industry the funding increases have gone overwhelmingly to “mega rounds” of late stage investments with round sizes of $100 million or more. In fact, the “traditional VC” market has only grown 14% per year and mega-rounds now account for nearly half of the dollars in the industry.

If you look even more closely you’ll see just how skewed the data really is. $21 billion of funding last year (16% of the market) came from deals in which investors put in $1 billion or more and a whopping $40 billion came from deals of $100 million or more. Taken together these “mega rounds” represent nearly half of the funding in 2018. We have chosen to define “growth rounds” as rounds of $100 million or more but if you include deals of $50 million or more (traditional growth or mezzanine rounds) this accounts for 62% of the entire startup funding market.

3. This huge increase of capital is really just money that used to be invested post-IPO, so more value is captured by VCs who traditionally sold post-IPO

In a way we see this late-stage capital as a different market segment than traditional venture capital but it gets lumped into the same classification. The best way of thinking about this “value capture” accrued to VCs and not public-market investors is to look at what happened a generation ago.

If you look at some high-profile tech companies funded in the last big VC cycle you had eBay, Amazon, Salesforce & Google each go public having raised < $100 million in VC TOTAL prior to IPO and their last private-market valuation were all sub $400 million.

If you fast forward one generation of tech companies it’s a completely different story. Companies are raising billions of dollars in the private markets and the valuations are enormous PRIOR to the IPO. Yes, distributions to LPs have been pushed out a few years but the value capture in privates by the best VC firms (and best LPs) has been enormous.

In fact, if just Google, Salesforce and Amazon has stayed private for 12 years (today’s IPO benchmark) an addition $200 billion would have been captured in the private markets! This is cutting it as just 12 years after inception, which is even before Amazon and Google’s big stock-market runs in which these three companies have created $1.64 trillion in value.

If you look at the blue line below in what we are calling “private-market IPOs” you’ll see the discernible trend that began in 2014 and has continued through 2018 and you’ll see the impact this has potentially had on public IPOs in green.

4. If you get into the best deals it has never been a better time to be a VC or LP, and the best have developed strategies to capture more value

Given that the best deals are pushing out their exit dates it means that many firms aren’t seeing as quick of liquidity as they might have 20 years ago. On the other hand, the best firms have developed strategies to capture more value while their best portfolio companies stay private.

Some of the earliest-stage funds have set up SPVs because they are at times easier and faster to raise than new funds. These have the benefit to VCs of not cross-collateralizing returns and to LPs of being able to know the underlying asset before they write the check. But there are clear pro’s and con’s.

A typical strategy has been for Series A VCs to raise “Opportunity Funds” that double down by taking up the pro rata rights of a firm’s best deals. If you get into a high-growth company and you have asymmetric information on how the management team is performing — this seems like amongst the most valuable investment available because it’s not necessarily fully priced like a public-market investment.

And finally the best of the best are able to raise “growth funds” to complement their early-stage funds. These allow a combination of investing in pro rata in existing “best deals” while also jumping into other great deals one’s early-stage fund may have missed. That is why you’ve seen so many VC firms that only 20 years ago have $150 million funds raise $ billion growth vehicle. Follow the money.

In reality the “private capital market” now really consists of three distinct markets: Seed capital (the start), Venture capital (scale or bust) and Growth Capital (private IPOs). The skills in each are quite distinct, the investment strategies are different yet the connective tissues between the best firms are strong.

Still reading? Maybe add your email to receive the next post delivered to your email box? The second half of this analysis coming soon!

5. Why $55 billion now is infinitely better than 1999

It’s intuitively obvious to most investors once you think about it but it’s easy to get caught in the simple trap of “we’ve returned to 1999 levels.” So here’s a reminder of why 2019 is 10000x better than 20 years ago.

“We are all now online and at significantly greater speeds with computers in our pockets that are one-click from purchasing anything and recommending the best products to everybody we know through social networks. As a result the best companies grow faster than any time in human history. And this is about to grow even faster.”

Want some context? Here are some simple slides that outline the point:

a. There are significantly more Internet users and we’re no longer newbies

b. We are connected at speeds 400x faster and this is about to explode into significantly greater speeds with 5G that are the equivalent of a platform shift

c. We all have computers in our pockets now

d. We have removed all “purchase friction”

You see, you like, you buy.

e. We are now all social. When we like something it spreads like wild fire

6. What does this all mean?

So, yeah. VC is still a thing 🙂

If you want to see the full deck you can download it on Slideshare or in the embed below.

A Deep Dive into What Has Really Changed in Venture Capital was originally published in Both Sides of the Table on Medium, where people are continuing the conversation by highlighting and responding to this story.