Venture Capital is Swimming Upstream: Why?

Thursday Nov 14, 2013 by Nick Petri - Market Research Analyst, OpenView Venture Partners

A Surprising Trend in VCs

A few days ago, Pitchbook released their Q4 valuation and trends report. While the quarterly data is always a bit noisy, there’s one long-term trend I find especially interesting:

On the whole, VCs are investing in fewer, bigger companies.

Although more investors are focusing on the seed stage than ever before, the median valuations at each stage (including seed) have risen over the past 2-3 years. In contrast, the total number of deals has fallen. To put it another way, companies are waiting for higher valuations before raising money. While there are a few different charts that show this from various angles, it’s this one that really hammers home the point:

Image provided by: {link:http://www.pitchbook.com}Pitchbook{/link}

Across the board, median funding rounds have gone up about 25-75% in just three years. That’s a pretty shocking increase.

So What’s Behind this Surprising Venture Capital Trend?

I can think of a few different reasons why companies and VCs would both be waiting until later in a company’s lifecycle to make a deal.

1) More Companies are Bootstrapping

With startup costs on a well-documented decline due to cloud computing, perhaps companies are waiting longer to raise their first round of funding. This of course means bigger seed rounds, but the ramifications also ripple through the entire VC structure — each round of investors is looking for a minimum return on their capital before exiting.

2) Crowdfunding is Making an Impact

As crowdfunding becomes a legitimate 3rd option to bootstrapping and VC/Angel capital (though I still have my reservations), perhaps it’s driving seed investors further upstream. While I don’t have apples-to-apples figures on the size of the crowdfunding market, it’s certainly multiple billions of dollars. I’d be shocked if it didn’t have some impact on the $6 billion dollar seed funding market.

3) Healthy Public Markets are Buoying Valuations

After a few years of volatility in the aftermath of the 2008 economic collapse, the stock market has rebounded sharply in 2012 and 2013. VC-backed IPOs have been no exception. This is likely buoying valuations up and down the growth spectrum. This would also explain the declining number of late-stage deals. Companies are more willing to put themselves at the mercy of the public markets than they were during the inclement conditions in 2008-2010, and therefore need less late-stage ‘bridge’ finance.

4) The Value-Add VC Business Model is Catching On

The prior three dynamics are all “pull” factors for why companies would be changing when and at what valuation they choose to raise funds. But we all know it takes two to tango. Perhaps VCs are pursuing later-stage companies themselves. As the market has gotten more competitive, more VCs are moving away from the “spray and pray” model, making fewer investments, and dedicating more resources to ensure success. This model goes hand in hand with higher valuations and more concentration, as VCs can’t afford to throw resources at companies that are likely to fail.

Looking Ahead

I can’t say for certain that this upstream trend in VC will persist. However, at least three of the reasons above (#1, 2, and 4) seem like long-term, structural changes to the capital markets that will continue for years to come. If, on the other hand, #3 is the primary culprit, we could see the trend reverse if the public markets can’t keep their streak alive.

Either way, I’ll be on the lookout for Pitchbook’s next report.

Nick Petri is a Market Research Analyst at OpenView Venture Partners.  You can find this post, as well as additional content on the OpenView Blog located here.  You can also follow Nick on Twitter (@NCPetri) by clicking here.

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