A warts and all retrospective of venture capital over the past few decades.
In 2008, in the midst of the financial crisis, the Fed cut interest rates as part of a frantic effort to avert a second Great Depression. The Fed also enacted quantitative easing, buying securities itself in an effort to push effective interest rates below zero. This “zero interest-rate policy” – otherwise known as ZIRP – was only meant to be temporary – but, when Congress wasn’t forthcoming with stimulus spending, the Fed decided to keep ZIRP in place indefinitely.
With rates so low, investors were no longer able to earn nice returns by stashing money in safe assets – like US Treasury bills. Borrowing costs plummeted, cheap money proliferated and investor capital flowed into riskier asset classes – like publicly traded stocks or property development.
This influx of investment sent asset prices soaring. In what’s become known as ‘“the everything bubble”, almost every single asset class, from bonds, to private equity, to cryptocurrency sky-rocketed. The US stock market rose more than 580% after the financial crisis, accounting for price gains and dividend payments. At the same time, the tech giants Amazon, Netflix and Tesla set a new precedent for how valuable a technology company could become.
The Global Financial Crisis kick-started the era of easy money, and venture capital (VC) saw a surge in popularity, with many individuals entering the field due to high returns and a perceptions of it being easy and fun. As one of the few legitimate financial products with the potential to offer a thousand-fold return on investment, the VC ecosystem became absolutely flush with cash – and they needed to spend it.
Treasury investors shifted to corporate debt. Public equity hedge funds shifted to late-stage private equity. Late-stage private equity shifted to mid-stage, mid-stage to early stage. Seed rounds become bigger. Angel investors become a thing. Unicorns, unicorns, and more unicorns. [ReadMargins]
By 2015, global VC funding amounted to £128.5B. By 2019, it was $254B. Most of this money flowed into tech startups, from 2010 through 2020, tech startups made up a majority of venture funding. VC loves tech startups, they typically require small amounts of capital to start and are relatively capital-efficient to scale. With low/no marginal costs, many can benefit from outsized returns to effort ie. WhatsApp: 55 employees serving 420 million users and selling to Facebook for $19B.
In the face of so much capital, companies succumbed to temptation – soon enough everyone was a ‘technology company’ raising at tech valuations under the guise of innovation and and disruption. From Casper, an online mattress company ($100m raised at $1.1Bn valuation), to Zume, a pizza delivery company ($375m raised at a $1.5Bn valuation), to Juicero, a fruit and vegetable juice company ($120m raised at a $400m valuation).
We’ve all come to use the phrase “ZIRP phenomenon” to describe inflated VC rounds, inflated salaries, generous workplace perks, gravity-defying valuations, and logic-defying business models. [Angular Ventures]
Plentiful money fuelled exuberance — founders were encouraged by their investors to spend money like it was going out of fashion. ‘Growth at all costs’ became an entrenched part of the Silicon Valley zeitgeist. Tech companies began to ‘pay to win’ spending heavily on advertising, sales and user acquisition, buying users and growth (and the high valuations that comes with it).
Credit to Tony Yiu for a beautiful summary of this unsustainable cycle:
Venture capital rushes into startups.
Those startups spend that money on marketing (and consuming each other’s SAAS software), which allows them to rapidly scale their user bases and revenues (but no profit because spend > sales).
The rapid growth pushes up valuations of those startups, which attracts more venture capital at even higher valuations. Naturally, this also allows the venture funds that got in previously to record very high returns.
The new capital from step 3 lets the startups spend even more on user acquisition, advertising, etc., continuing the cycle.
The era of easy money snowballed exponentially until a COVID crescendo. In March 2020, as part of wide-ranging emergency action in the face of the coronavirus pandemic, the Fed repeated history, dropping interest rates to ~zero, restarting quantitative easing and distributing trillions of dollars to large swathes of the US population as part of lockdown relief.
Cashed up, locked in and with little to do in their leisure time, consumers moved online and eCommerce exploded. Americans spent $1.7 trillion online during the last two years of pandemic. That’s $609B more than the two years before Covid. The pandemic also accelerated digital transformation. Businesses and individuals increasingly relied on technology to adapt to remote work, online education, telehealth, and virtual communication.
The surge in remote work and reliance on digital platforms led to increased demand for technology services. Companies providing collaboration tools, cloud computing, cybersecurity, and e-commerce solutions, among others, experienced heightened demand for their products and services
Technology was having its heyday and everyone piled in. Hedge funds, private equity firms, sovereign wealth funds, corporate VCs and mutual funds supplied two-thirds of the $621B invested into venture capital 2021. The size of venture funds exploded as investors put ever-larger amounts of capital to work. As demand for deals grew, so did valuations. In a seller’s market, founders had the driving seat when it came to valuations and terms.
Fear of missing out (FOMO) proliferated and it wasn’t just high prices investors were prepared to pay to not miss the boat: investment discipline loosened. The periods for conducting due-diligence drastically shortened, protective provisions disappeared from term sheets and investors no-longer demanded board seats. At one point “crossover” fund Tiger Global Management was doing a deal a day, including on weekends.
Stupid ideas and shady founders enjoyed easy access to hundreds of millions even billions of dollars. Unicorns proliferated – more unicorns were minted in 2021 than the past five years combined and silly season began. Hopin, a virtual events company, hit a $5B valuation within 21 months of launch. Gorillas, an on-demand delivery company, achieved a >$1B valuation within 9 months. Cazoo, the online car retailer, surpassed a $1B valuation within 6 months.
With massive multiples, revenue growth driven in part by government stimulus, money drops, and low cost of capital, tech companies went on hiring rampages. Tech wage inflation accelerated boosting compensation for key roles by up to 20%. Startups, often pre-product market fit but buoyed by venture capital, frequently hired rapidly ahead of revenue and traction.
In the past a $1M ARR company would often have 5-20 employees. During COVID, some companies ballooned their employee counts regardless of revenue (in one example a company reached almost 400 employees on less than $1M in revenue before shutting down in 2022). [Elad Gil]
2022 proved a rude awakening. The pandemic boom had seen many companies crowned as unicorns, thousands of hires made, and new markets opened up. It also saw rampant inflation, and given that many governments coordinated their actions, inflation was not limited just to the USA.
In February 2022, Russia invaded Ukraine with devastating human and economic consequences. The attack placed a further squeeze on critical commodities. Costs that were already high, climbed even further, triggering inflation rates that far outpaced wage growth. In March 2022, in an effort to curb inflation, the Fed (and other countries equivalents) raised interest rates.
Interest rates determine how deeply you discount future cash flows, particularly for growth stage companies. When interest rates are higher, growth multiples compress and stock prices drop. April 2022 was a terrible month for stock markets and particularly bad for tech stocks – the Nasdaq dropped 13.3 percent the worst monthly performance since October 2008.
In response, venture capital funds and investors took to X (née Twitter) warning founders that tough times were coming and to buckle their belts. In May 2022, venture stalwart and occasional soothsayer Sequioa Capital published a 52-slide deck called “Adapting to Endure” laying out a litany of risks that would make it harder for founders to raise money and operate.
A cold-water realisation was washing over the startup community; with capital now constrained, the expensive race for growth no longer made sense. Where startups were once encouraged — even incentivised — to remain loss-making in order to gain market share. Now they were being told to focus on profitability. For many startups it was the beginning of the end, they’d built a balance sheet but no business and a reckoning was coming.
“It’s not necessarily these founders’ fault that they’ve been hearing one story from VCs about grow, grow, grow, and seemingly overnight, that story changed to the bottom line, bottom line, bottom line.” [Andrea Hippeau]
Companies moved to cut or freeze headcount and preserve cash at all costs. Growth rates slowed and later-stage startup valuations went into free fall. Perhaps the most visible example of this was Klarna, the European buy-now-pay-later provider. Exactly 12 months after being valued at $45.6B, its valuation dropped 85% to $6.7B.
2022 began with fears of a downturn after the historic highs of 2021, and ended with those fears fully realised. Median valuations trended down at every stage. Seed and Series A valuations ticked down only slightly, but later stages experienced much larger drops, reaching their lowest point since the 2010s.
All in all, 2022 saw 1023 tech companies lay off 153,256 workers. Global startup investment declined by a third. The number of mega-rounds, in which startups raise $100m or more, fell by 71%. Unicorns, became rare again: the number of newborns contracted by 86%.
Liquidity all but disappeared, only $71.4B was generated in exit value, a 90.5% decline from 2021′s record of $753.2B. It was the first time exit value fell below $100B since 2016, with late-stage companies the hardest hit. Public offerings of VC-backed companies fell to a level not seen since the early 1990s, with just 14 public listings in the fourth quarter of 2022.
Hundreds of VC firms were now dead-men walking. Thanks to FOMO, they’d overspent and overpaid during the boom cycle – now the tide had gone out, they were left holding inflated paper returns with little chance of liquidity and no chance of persuading increasingly cautious LPs to invest in their next fund.
The era of easy money was well and truly over.
The gloom continued into 2023.
The scarcity of IPO exits, a pullback from nontraditional investors, ongoing economic headwinds and the collapse of Silicon Valley Bank (SVB) all contributed to the worst year for venture fundraising since 2015, with funds raising just $161B versus $307B a year ago. The slowdown was also evident from reports of reduced headcounts (including Anthemis, Sequoia Capital and Y Combinator) and missed fundraising targets (including Greycroft, Insight Partners and TCV).
Investors deployed capital more sparingly, with a higher bar at each stage. Global deal activity fell to ~$345B, down from $531B in 2022. Companies that saw high revenue multiples during the venture frenzy of 2020 and 2021 experienced hefty down rounds, particularly in once-celebrated sectors such as fintech, cryptocurrency, and the creator economy. Late-stage deals, in particular, became rarer, smaller, and cheaper.
In the tighter funding environment, many VCs favoured their existing portfolio over new deals, supporting their best-performing startups through extensions, bridges, or insider-priced funding rounds. In Q2 2023, bridge rounds comprised 38% of all fundings raised by companies whose latest priced round was a Series C.
Rebuilds take time as the industry slowly works through previous sins, & slowly regains confidence. Risk off is very fast. Risk-on is very slow. [Bill Gurley]
While most sectors declined, AI was one of the few winners. Global funding to AI startups reached close to $50 billion last year, up 9% from the $45.8 billion invested in 2022. Interestingly, most of the funding came from Microsoft, Nvidia and Google, who crowded out many traditional tech investors for the biggest deals in the industry.
Exits were tepid. The much vaunted $20B acquisition of Figma by Adobe was cancelled following pressure from European regulators. Large tech initial public offerings (IPOs) remained elusive. Public debuts from Arm, Klaviyo and Instacart sparked a glimmer of hope that public markets might be opening again. This was quickly extinguished by underwhelming after-market performance, reflecting ongoing mismatched valuation expectations between issuers and investors.
High-profile startups dropped like flies. WeWork collapsed into bankruptcy. The e-scooter company Bird, which became the fastest company to ever land a $1B valuation, is now worth less than $7m. SmileDirectClub, having raised $427m to revolutionise traditional orthodontics, ceased trading. Overall, more than 3,200 private venture-backed US startups went out of business.
The collapse of WeWork, a symbol of all the venture hubris of the last few decades seemed a particularly fitting end to this year (and this article).
Till next month.