The venture capital bubble is facing a slow and messy unwinding. After a historic boom that puts even the tech bubble of the 1990s into the shade, and adjustment to more rational conditions has started. But structural factors and the psychology of private markets make it in our opinion hard to tell how long this will take or what will emerge on the other side. Two contrasting pieces of news this month make the point. One is the confirmation that Klarna has had to accept a radically lower valuation in order to raise fresh capital. The Swedish “buy now, pay later” company’s latest fundraising values it at 5.9 billion US dollar before the injection of new cash, an 87% slide.
The other is that there is more money than ever trying to crowd into the venture capital (VC) market. At the end of June, venture funds had a record 290 billion US dollar on hand waiting to be invested, according to data from Pitch Book. That is fully 100 billion US dollar more than was burning a hole in their pockets as recently as 18 months ago. Normally you might expect a tidal wave of cash like this to buoy up valuations. But for companies such as Klarna, with a need for money in a hurry while burning cash, the terms have suddenly become punishing.
One result in our opinion is that the number of mega-fundraising – the 100 million US dollar – plus rounds that characterized the boom – dropped by nearly a third in the second quarter, according to CB Insights. Yet the number of fundraisings is in our opinion still abnormally high on any historical comparison. It will most probably take some more time for reality to settle in.
After a collapse in growth stock valuations in the public stock market, a rapid reset in the private world might seem inevitable. But currently 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 the growth targets, particularly in the relatively early stages, bowing to Wall Street’s new view of reality seems like an act of self – flagellation, particularly since you aren’t even public. A downward – raising money at a lower valuation than the previous round – punishes the wallet by diluting existing investors and feels like an unjustified admission of failure.
Maintaining the fiction that nothing has changed carries in our opinion other benefits. For one thing, it means you can keep issuing restricted stock and options to employees and outside workers at the old valuation levels, as long as the employees are happy to go along with it. Investors also have plenty of reasons to bury their heads in the sand. For years, many start-ups have seen upward – only revaluations from successive rounds of capital. The investment managers at the limited partners that provide VC firms with cash were able to show their own investment committees returns that were heading in only one direction – and collect healthy bonuses along the way. Why rock the boat now when there are no requirements to force a revaluation in the other direction?
The other big distortion that is preventing a quicker return to normality is in our opinion the massive overhang of capital. How long this will take to unwind is hard to forecast.
Even the 290 billion US dollar held by venture funds doesn’t catch the full picture, since the real glut of capital in recent years has come from beyond the traditional venture world. Hedge funds, private equity funds, mutual funds, corporate VCs and sovereign wealth investors have had a staggering impact on the market. Last year, according to Pitch Book, this group of investors pumped 500 billion US dollar into start-ups globally, or twice as much as all the money invested by traditional VCs. This was up from only 180 billion US dollar the year before.
Investors such as SoftBank and Tiger Global which have taken some big knocks may retreat, but will others be waiting to take up the slack? History, after all, suggests this is exactly the right time to put more money to work in the start-up world. Investors who piled in at the top of the last tech bubble, in 1999, took big losses – but venture money invested in the more sober period that followed is reputed to have brought stellar returns.
All of this means that given the sheer scale of this bubble that is in our opinion soon ending, venture’s realignment with reality will take some time. But as Klarna found out to its cost this month, the real good times are most definitely coming to an end.