Amid Falling Valuations, VC Industry Is Bruised but Not Broken

The recent slide in valuations of late-stage, privately held technology companies has put a damper on venture capital funding — and will likely continue to do so — but market participants say that deals will continue to get done. “This is more a periodic adjustment, not an existential threat, to start-ups and VCs,” says Simon Olson, a former partner at venture capital firm DFJ FIR Capital Brazil, who now heads Galactic, a São Paulo–based wealth management start-up. “Fund returns will suffer. Companies and their employees will suffer. But there are still smart people doing interesting things, and new technologies being born.”

Some of the blame in this affair should be shouldered by venture capital firms, Olson and others say. “They could have avoided this by taking money off the table in later rounds,” he explains. “They were victims of their own success.”

Venture capital firms’ strategy of investing in numerous early-stage companies and then doubling down on the winners didn’t work so well when the valuations of the winners started to slide. That doubling down is a new phenomenon. In recent years VC firms became obsessed with the model of large numbers and strayed from prudent money management, Olson maintains.

Venture capital firms reacted predictably to the decline in valuations of former market darlings. Last year global venture capital funding plunged 30 percent, from $38.7 billion in the third quarter to $27.2 billion in the fourth quarter, according to New York–based research firm CB Insights. A total of 1,742 deals were executed during the three final months of 2015, the lowest number since the first quarter of 2013. CB Insights cites 57 private companies that executed a down round or a down exit — that is, at a lower valuation than its last funding round — since the beginning of last year.

The list includes wearable technology company Jawbone and Gilt Groupe, a shopping web site that offers flash deals on high-end items. Jawbone’s down round in January provided a valuation of $1.5 billion for the San Francisco company, down from $3.3 billion previously. Toronto-based retailer Hudson’s Bay Co., which also owns brick-and-mortar standbys Lord & Taylor and Saks Fifth Avenue, bought Gilt Groupe that same month for $250 million, down from its prior valuation of $1.05 billion.

“For late-stage investing, winter is here,” says Venky Ganesan, managing director of Menlo Ventures, a VC firm in Menlo Park, California. “Late-stage companies that are fond of Red Bull, Twizzlers and foosball are finding the reality of building a company is difficult.”

Many venture capital participants agree that young companies’ executives had grown too obsessed with reaching the $1 billion valuation level, which in Silicon Valley parlance would make their companies unicorns. CB Insights cites 155 unicorns, led by car-sharing service Uber Technologies, with a valuation of $62.5 billion, Chinese smartphone maker Xiaomi ($46 billion) and accommodation-sharing web site Airbnb ($25.5 billion).

“Given that they are a mythical creature in the first place, the idea of a herd of unicorns in an oxymoron,” says Mark Leslie, former CEO of Veritas Software Corp. and now a venture capital investor.

Leslie compares the various stages of private company investing to a ladder: “When the IPO market freezes up, and public investment in private markets freezes up, which they have, it ripples down.” But he and others view the process as a necessary cleansing, making venture capital firms more selective as to which deals they finance. “The same guys throwing money at deals a year ago are now saying, ‘Whoa,’” Leslie adds. “The companies that prove they can deliver real value to the customer and eventually earn profits will continue to get funded.”

The downturn in valuations actually began in the public markets, with the plummet for companies such as online crafts marketplace Etsy, whose share price is down about 70 percent since its April 2015 IPO, and wearable fitness technology maker Fitbit, whose stock is down 72 percent from its August 5 peak of $51.64. Historically, Olson notes, public market valuations drive private ones.

In recent years, low interest rates led investors to chase returns, sending them to the private markets. Even mutual funds entered the fray. And that drove up valuations, pushing them out of whack with those in the public markets. “The needle breaking the bubble was that mutual funds had to mark their investments to market,” Olson says. “And that pushed private valuations closer to their public counterparts.”

Menlo Ventures’ Ganesan stresses the distinction between early- and late-stage companies, calling it a “Tale of Two Cities.” For early-stage companies, the environment won’t change much, and his firm remains as excited as ever about them. Cloud computing, cybersecurity, mobile technology and big data remain promising investment areas, he says, but companies offering subsidized consumer goods and services won’t survive. “You can only give away other people’s money for so long,” Ganesan adds.