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Outsize Venture Capital Deals Too Big for Their Own Good

Massive valuations on companies such as Dropbox illustrate venture capital’s move away from financing early-stage projects.

On January 17 the Wall Street Journal reported that Dropbox had received $250 million in financing led by BlackRock, the world’s largest asset management firm. The deal valued the San Francisco–based online storage and sharing service company at $10 billion and, according to the Journal, was rumored to include earlier Dropbox investors Accel Partners, Goldman Sachs, Index Ventures and Sequoia Capital.

Opinions on the soundness of the deal are mixed. What is clear, however, is that such giant valuations and the massive financing directed by them are distorting the venture capital process and causing a massive misallocation of capital.

Venture capitalists completed 30 deals of $100 million or more in 2013, according to PitchBook, the Seattle-based private equity and venture capital database. Deals of $25 million or more rose to 21 percent of all late-stage investments in 2013, compared with only 11 percent the year before.

By contrast, the number of early-stage financings fell to 44 percent of deal flow, from a high of 59 percent in 2005. More significantly, the total number of first-time financing deals fell 33 percent, from 1,833 in 2012 to 1,203, in 2013. Capital for first-time financing deals also fell, to $4.13 billion in 2013 from $4.93 billion in 2012.

Over the long term, the Cambridge Associates U.S. venture capital early-stage index has vastly outperformed the Cambridge Associates late- and expansion-stage index, as well as the multistage index, on an annual basis. In the 30-year period ended September 30, the early-stage index returned 20.52 percent, compared with 12.38 percent for late- and expansion-stage and 11.50 percent for multistage.

Nonetheless, “there’s little real money going into innovation financing,” says Yatin Mundkur, a partner of East Palo Alto, California–based Artiman Ventures, one of a handful of venture funds that is still investing in early-stage, innovative companies. Over time, as venture capital under management grew, many funds found that they just did not want to invest small sums of money — say, $250,000 — on a deal with numerous unknowns, opting to put more money into companies at a later stage.

Forced by a giant overhang of venture capital — unspent funds total nearly $58 billion — and pressure to compete with other alternative assets, venture capital firms are deploying capital in bigger chunks. Seed deals are getting short shrift. In 1995 seed deals accounted for 19.1 percent of all deals and 11.2 percent of the amount invested. In 2013 they accounted for only 5.5 percent of all deals and 3.2 percent of the capital.

Incubators and accelerators say they are trying to fill the seed capital gap. And although there are estimates of more than 2,000 incubators and accelerators worldwide, their overall impact on creating durable, innovative businesses is considered small. The explosion of incubators and accelerators is misleading, says Mundkur. Whereas they have become home to a legion of young entrepreneurs, the actual capital they generally provide is insufficient to prove a concept or fully develop an idea. “It’s eye candy,” he says.

Incubators and accelerators have become a business by themselves, others say. They seem more in the business of acquiring cheap equity than nurturing innovation.

“You know what I’m tired of? Rich guys launching start-up accelerators so they can rip off new start-up founders,” Ryan Carson blogged a few years ago. Carson, co-founder and CEO of Treehouse, an online programming and mobile app development school, pointed to Oxygen Accelerator, a start-up accelerator with operations in Birmingham and at the London Google Campus that offered each tenant a £20,000 ($32,754) loan in exchange for 6 percent of the tenant company. “The reason why I know this is a terrible deal is because we just got a bank loan for £100,000, and we gave up exactly zero equity,” noted Carson.

Of greater concern is the fact that most incubators and accelerators tend to focus on the most obvious technologies, often without any new intellectual property, says Mundkur. Since the focus of such companies is on quick fixes, they are often draining talent and resources away from more critical and complex technologies that take time to shape and develop. Many of these incubators and accelerators are contributing more to a misallocation of critical resources than to investing in new concepts.

Much of this would be of no concern if the entire tilt of venture capital was not toward late-stage deals that offer low risk. “What we now have, for the most part, is an industry that is like the mezzanine industry of the past, an industry that is moving away from its roots,” says New York venture capitalist Robert Raucci of Newlight Management. But in participating in massive financing deals, venture capital is competing with other alternative asset classes such as private equity, and even hedge funds, that can put up more capital. In 2013, for example, private equity funds raised $193.7 billion across 210 funds. Venture capital funds, by contrast, raised a total of $16.7 billion across 185 funds, according to a report by industry trade group National Venture Capital Association and Thomson Reuters. This trend marks a 15 percent decrease in dollar terms from 2012 and the weakest showing since 2010. “If it’s capital, private equity funds can provide it cheaper,” says Raucci.

The BlackRock-led firms that invested $250 million in Dropbox received only a 2.5 percent stake, based on the $10 billion postmoney valuation, far less than what most venture capitalists would ask. Still, they are thankful for the overvaluations. “It is a reflection of how much BlackRock values the company,” says David Beatty, angel investor and managing director of Golden Seeds, a New York–headquartered investment firm that focuses on female entrepreneurs.

BlackRock’s involvement is not happenstance. Firms such as BlackRock use a battery of experts to analyze deals, especially ones that tend to be as visible as this one. Their investment puts a value not only on the company but also on the technology, says Beatty.

Overvaluations also are being driven by some of the lofty prices that private companies are fetching in the M&A market. Google paid $3.2 billion for Nest Labs, a four-year-old Palo Alto–based company that sells thermostats and alarm systems that can be set online, and, last summer, $1 billion for five-year-old Ra’anana, Israel–based Waze, a crowdsourced mapping software provider. Also on Google’s roster of recent buys is DeepMind Technologies, a London-based artificial intelligence company with no publicly known product in the market. Says Beatty: “Some valuations may have nothing to do with the value inherent in a company but what investors think it may be worth to an acquirer.” As for Google’s valuation of DeepMind, initial reports put the transaction at £242 million ($400 million); later reports, citing confirmation with Google, say the deal is worth £300 million. U.K. newspapers the Guardian and Telegraph report the figure as £400 million.

Deals priced anywhere from $30 million to $100 million or more for companies with no sales or even no products are becoming more common. “That’s the extreme end of the market,” says San Francisco–based angel investor Jerry Newman, who has invested in businesses such as Cyras Systems, a developer of optical switching systems for metropolitan areas that was acquired by Linthicum, Maryland–based networking company Ciena Corp. “Such astronomical valuations don’t affect what happens to start-up investing.”

The other end of the market is a throwback to traditional venture capital, inhabited by only a handful of venture capital firms that continue to focus on investing early in innovation and building companies from the ground up, instead of just on apps.

The gap between the two ends of the venture capital spectrum is not likely to go away soon. But unless there is real innovation to build on — and institutional investors in venture capital find ways to promote the few funds that are truly innovative — there will be just too much venture capital funds flowing through the market to gain palpable returns. Entrepreneurs have an increasing array of funding options, including accelerators such as the U.K.’s Oxygen Accelerator and crowdfunding. Institutional investors looking to allocate to venture capital funds may want to look to these newly built funding platforms for ideas on projects to target. For example, an investor could gauge which projects are getting the most attention on Kickstarter, Seedrs and the like. The late-1990s dot-com boom has long since gone bust. Many venture capitalists would do well to update their strategies beyond the cargo pants years.

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