I'm asked pretty frequently these days about the impact of the rising market on the venture business. People want to know if VCs are putting more money to work now that the market has stabilized a bit and it looks like there may be an IPO market some day soon. It's a perfectly reasonable question and the short answer is "yes." But the full answer is much more involved.
Venture investing can't be viewed in a bubble (pun intended). The financing process is very much informed not only by the nature of the company seeking funding but the financial markets in which that company finds itself. VCs invest in companies with the expectation that at least in some instances there will be liquidity and positive returns. For venture investors, liquidity can only reasonable mean two things -- the company goes public and therefore has stock that can be publicly traded, or the company is acquired for some liquid asset (cash or stock). These potential liquidity events drive valuations throughout a startup company's financing cycle and, therefore, have a real impact upon the nature and frequency of venture investing.
To give you a sense of how the IPO market impacts valuations throughout the life cycle of a company, it may be helpful to look back to the late 90's when everything seemed to work. During that perfect IPO storm, the ability to get a technology company public was practically a foregone conclusion. As a result, companies found it pretty easy to get funded through liquidity. A company would raise a couple million dollars in angel money at something like a $10 million pre-money valuation. That company would build out some proof of concept and go raise a Series A round of $6 or $8 million at, say, a $25 million pre-money valuation. After another year or so of development and growth, the company would then go out and raise a Series B round of tens of millions of dollars at a valuation of hundreds of millions. Investors would line up to get their money into these companies at any ridiculous price because in a matter of months the company would go public at a billion dollar valuation and trade up to multiple billions in a matter of days. The end result was that everyone who invested throughout the cycle, at whatever price, made money. Companies got funded left and right, and made their way incredibly quickly through this funding process, driven by the IPO gold rush and the hopes of a near term public offering and the associated fortunes.
Pop! In 2000 the bubble burst. The pendulum rocketed back the other direction. And suddenly it was impossible to get anything public. Good companies with real business models were stuck in neutral. While there were lots of companies that didn't deserve to be public in the late 90's, the extreme market correction mirrored the over-exuberance of the bubble. Now there was nowhere to go but down, nothing was going public and what few M&A deals were getting done were by and large fire sales. Now there were no good outcomes for investors, no matter what the company.
Faced with the inability to get a company public or sell it at a reasonable valuation, many venture investors retreated under their desks. The financing cycle of progressively increasing valuations became much more difficult to predict. Because there was no near term public market, it became very difficult to find late stage investors. Late stage investors are willing to put money into companies at high valuations because much of the risk around those companies has been shaken out. The late stage money will be used to scale the business, accelerate predictable growth curves and drive to a liquidity event. Late stage guys thrive on predictability -- it is integral to their business model. Yet it became increasingly difficult to predict any path to liquidity. As a result, it became very difficult to raise late stage money at a reasonable valuation.
Faced with the inability to raise late stage money at a reasonably high valuation, companies found it increasingly difficult to raise earlier stage money. After all, the only way that a private investor is "paid" for his investment in a company is to sell equity in that company at a higher price than was originally paid. If it was not clear that a company would be able to raise money at a higher valuation in the future, it often made economic sense for a venture investor to simply wait until the company came back for funding at a later date. By delaying a funding decision, VCs were able to (1) eliminate a lot of risk in the deal and (2) potentially pay a lower price for the equity than would have been the case months earlier. Of course, that sort of thinking also resulted in lots of companies going out of business – companies were unable to raise money in the current round because so many investors were sitting on the sidelines waiting to fund the "next round" at a better valuation (everyone waiting for the "next round," it is a bit like waiting for Godot – that next round will never come). Those rounds that did get done, by and large got done on harsher terms than had been the case for some time. The terms often included large up front liquidation preferences, repurchase rights, etc., all of which were designed to give the investor coming into a deal some ability to make money even when the potential liquidity events were relatively modest on an absolute basis. And, of course, financing terms have a half life – these harsher terms made it harder for companies to raise money in the future on better terms because future investors wanted at least the same protections afforded the last investors in the company.
Faced with the increasing difficulty in raising money from professional investors, it became equally difficult for companies to raise angel money at a reasonable valuation. For angel investors, the key to success is the ability to seed fund interesting deals that will go on to get venture financed at a higher valuation by top tier venture investors When it became harder to predict what would get venture funded in the near term, angel investors began demanding more favorable terms. Suddenly the first million or so dollars into the company were costing founders a substantial portion of the total equity in the company. Which in tern made it more difficult to raise venture financing because the less equity the founding team owned, the less motivated they would be economically to make the company a success -- at some point it is possible to have sold so much of a company that the amount of equity that remains in the hands of the executives is insufficient to motivate them to stay, let alone work the tireless hours it takes to build a successful startup.
All of these factors have conspired to make it very difficult to get startups financed over the last three years or so. Entrepreneurs have often had to spend an immense amount of their time raising capital rather than building their businesses. And each time money has been raised, the new investor has taken a pound of flesh. Unfortunately, startups only have so many pounds of flesh to give. And many companies have died along the way.
Given all of that, it is not surprising to see increased private investing when the public markets finally show signs of life. With any luck, the existence of a stable, if not growing, public market will allow for the IPO window to reopen. And if the IPO window reopens, it will give late stage investors increased confidence to put money to work at higher valuations. And if late stage investors are willing to put money to work at higher valuations, early stage venture investors will be more likely to fund companies today on reasonable terms, rather than wait for the illusive "next round." And if early stage venture investors are willing to fund startups on more reasonable terms and are able to put more money to work, angel investors will seed fund more companies and demand less equity. And if angel investors demand less equity up front (which will percolate through the entire funding cycle), founders and executives will retain more equity in their companies and be more motivated to drive towards financial success. All of which will likely help build more successful companies, with more predictably positive outcomes.
So it is not surprising to hear about increased venture activity in the wake of an upswing in the public markets. Don't expect a sudden turnaround in the private equity community -- many investors got burned too quickly and too badly to jump back in without some caution this time around -- but if the market remains stable and new companies begin to go public and demonstrate some financial success, there will inevitably be a resurgence in startup funding. It is simply a question of confidence and predictability.
