The delayed rendezvous of venture capital with reality

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The venture capital bubble is facing a slow and messy unraveling. After a historic boom that even overshadows the tech bubble of the 1990s, an adjustment to more rational conditions has begun. But structural factors and the psychology of private markets make it hard to say how long this will take – or what will emerge on the other side.

Two contrasting pieces of news this week take stock. One is confirmation that Klarna had to accept a drastically lower valuation in order to raise new capital. The Swedes buy now, pay later, the company’s latest fundraising puts it at $5.9 billion before the injection of new funds, a drop of 87%.

The other is that there is more money than ever trying to cram into the venture capital market. At the end of June, venture capital funds had a record $290 billion waiting to be invested, according to data from PitchBook. That’s $100 billion more than was burning a hole in their pocket just 18 months ago.

Normally, you would expect a tidal wave of liquidity like this to drive up valuations. But for companies like Klarna, with a pressing need for cash, the terms have suddenly become punitive. One result is that the number of mega-fundraisers — the $100 million-plus rounds that characterized the boom — fell by almost a third in the second quarter, according to CB Insights. Yet the number of fundraisers is still abnormally high by any historical comparison.

It will take time for reality to set in. After a slump in growth stock valuations in the public stock market, a quick reset in the private world might seem inevitable. But there is almost no incentive for any of the participants to acknowledge that the good times are over. Quite the opposite, in fact.

For the founder of a successful start-up hitting his growth targets, especially at a relatively early stage, pandering to Wall Street’s new view of reality feels like an act of self-flagellation, especially since you’re not even public. A downturn – raising funds at a lower valuation than the previous round – punishes the portfolio by diluting existing investors and feels like an unwarranted admission of failure.

Maintaining the fiction that nothing has changed has other advantages. On the one hand, this means you can continue to issue worker-restricted stock and options at old valuation levels, as long as employees are happy to accept it.

Investors also have plenty of reasons to stick their heads in the sand. For years, many start-ups have only seen upward revaluations in successive funding rounds. LP investment managers who provide liquidity to venture capitalists were able to show their own investment committees returns that went in only one direction (and collect significant bonuses along the way). Why rock the boat now when there is no requirement to force a reassessment the other way?

The other major distortion preventing a faster return to normality is the massive over-indebtedness of capital. It is difficult to predict how long it will take to relax. Even the $290 billion held by venture capital funds does not paint the full picture, as the real glut of capital in recent years has come from beyond the traditional venture capital world.

Hedge funds, private equity funds, mutual funds, venture capitalists and sovereign investors have had a staggering impact on the market. Last year, according to PitchBook, this group of investors pumped $500 billion into startups around the world, twice as much as all the money invested by traditional VCs. That was up from just $180 billion the year before.

Investors such as SoftBank and Tiger Global, which have suffered big blows, could retreat, but will others wait to take over? History, after all, suggests that now is exactly the right time to put more money to work in the start-up world. Investors who huddled at the top of the last tech bubble, in 1999, suffered big losses – but venture capital money invested in the more sober period that followed is said to have brought stellar returns (though the lack of public data makes comparisons difficult).

All of this means that given the scale of the bubble that is ending, realigning the business with reality will take some time. But as Klarna found out the hard way this week, the good times are definitely coming to an end.

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