Smart choices are still (as they always have been) essential.
Venture capital investment reached a global record six-month total of $288 billion during the first half of 2021. That’s a gain of 61% versus the previous six-month record, in second half 2020, and almost triple the level just four years ago, in first half 2017.
Valuations too are surging. According to The Wall Street Journal on September 30, the average valuation of an early-stage U.S. startup during first half 2021 was $96 million, up 55% from $61.7 million in late 2020. The surge in valuations is taking place in later-stage ventures as well.
Exits are also off the charts, which counts even more. According to Pitchbook, more than a half-trillion dollars in exit value has been generated thus far this year. That is because investors are chasing innovation promising strong growth potential.
The surging venture capital market reflects extraordinary appetite for fast-growing companies in a broad market where sustained rapid growth is becoming harder to come by. Following several years of strong broad public stock market gains, savvy investors recognize that the days of broad growth may be coming to an end and that it’s time to focus on startups that could be tomorrow’s big winners.
The pandemic has heightened recognition of opportunities to leverage innovation to capitalize on healthcare needs and remote work trends that are expected to continue even after the pandemic. Climate change concerns are driving the broad quest for greener energy solutions. And geopolitical developments are beginning to spur further defense-related innovation.
Smart money is an important driver of the surging venture capital market.
Despite regulatory changes in recent years that were expected to broaden mass access to venture capital, access to high quality venture capital practically has remained restricted largely to “smart money” – institutions and accredited individual investors.
Pitchbook reports that nontraditional venture capital investors – including hedge funds, mutual funds, private equity firms, and corporate startup venture investors – have jumped in aggressively. And large university endowment funds (truly “smart money”) have been particularly active.
According to a 2020 study by the National Association of College and University Business Officers and TIAA, the leading provider of financial services to the academic world, endowment funds larger than $1 billion had an average venture capital allocation of 11%, versus 5% for endowment funds with assets of $500 million to $1 billion. Some university endowment funds allocate even greater shares of these funds to venture capital. The Yale University fund, America’s second largest university endowment fund and long recognized for its smart focus on alternative asset classes, has grown its venture capital allocation from 16% in 2016 to over 25% recently.
The Wall Street Journal cited huge returns for the year ending June 30, 2021 for several prestigious universities’ endowment funds, attributing those outstanding returns in important part to venture capital. This included total fund returns of 49% for the University of Virginia, 56% for Duke, and 65% for St. Louis-based Washington University.
Full disclosure: the impressive return figures reported by the university endowment funds do include unrealized gains as well, i.e. valuation increases for ventures that have not yet exited and delivered cash to investors. But venture capital’s consistently superior returns versus public stock markets has been documented repeatedly, and there are no signs of that reality changing.
While the surge in exits to half a trillion dollars in exit values thus far this year is undeniable, it’s also important that investors understand just what those numbers mean.
It does not mean that half a trillion dollars in cash has come raining down on the venture capital investors.
While exit values through M&A may often represent cash payments equal to the full exit values, IPOs — an important contributor to the total exit values — may in fact represent sales of a limited share of the company. The reported exit value reflects what the company’s valuation is based on all shares being valued at the price at which the limited number of new shares were sold.
The IPO may have been implemented as a more effective and efficient fundraising option versus another private venture capital round. That reported valuation may be encouraging to those earlier private investors, but it may not be the end of the road for them. The terms of a startup’s venture capital fundraising rounds may restrict the private investors from selling their shares for an extended period following IPO, often six months.
More importantly, even without such restrictions, it may be smarter for the private investors to hold onto their shares while the company’s business and its valuation continue to grow. Remember when Facebook IPO’ed at $38/share back in May 2012. Its share price today as we write this letter, 9 years later, is $342, a nine-fold gain.
We are not suggesting that every investor should or would want to wait nine years for a payout, but rather that smart choices as to when to hold and when to sell are important. In fact, IPO may be a purposeful smart tactic to increase the company’s visibility and appeal to subsequent M&A suitors, which might then result in a tremendous windfall for earlier venture capital investors.
VCapital seeks startups with solid business models expected to attract strong M&A interest.
In some cases, we may still pursue IPO as in our investors’ best interest, but that might be as a steppingstone to a subsequent, more lucrative M&A transaction. In our quest to maximize returns to our investors, we generally prefer the more predictable, disciplined financial thinking of savvy corporate suitors to the potential emotional roller coaster rides of the public market.
We believe that several of VCapital’s portfolio companies have such strong M&A appeal, the kind of M&A appeal that led to IBM’s $1.3 billion acquisition of Cleversafe. Major pharmaceutical company interest in Intensity Therapeutics is clearly evident. The active partnering of major defense contractors with Atlas Space Operations and immediate partnering of a major supplier to operating rooms with SentiAR signal potential suitor interest in those companies. Similarly, we expect portfolio companies such as EDJX and Ocient, Chris Gladwin’s sequel to Cleversafe, to attract such acquisition appetite. It’s possible, though, that some may have IPOs along the way toward maximizing investor returns.
Just remember that venture capital investment is a long game.
While acquisition suitors may occasionally jump on high potential startups quickly, more often they will wait to be more sure of their target’s value. Using an IPO as a smart steppingstone to a possible subsequent corporate sale is different than exuberant rush to public offering just because the public market is especially strong, leaving early VC investors vulnerable to sudden stock price drops. VCapital believes the ultimate investor reward is likely to be greater through our preferred path.
We would love to hear your thoughts. Talk to us.
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