The recent Square IPO, which valued the company about 40% below the preceding private financing value, supports the view that valuations of later-stage private start-ups are excessive and likely to decline: i.e., the unicorn bubble may soon deflate. Much of the discussion, however, has focused on the impact on investors in the preceding private financing rounds: what happens to them and whether they will continue to put high values on scaling private companies. I’m more concerned about what will happen to entrepreneurs.
Entrepreneurs care about: 1) making their vision real by helping customers and building a great company, 2) accessing capital to make that possible, and 3) making money. Great entrepreneurs care about making money but never put it first. Access to capital is most difficult at the Series A/B stage, when the company first needs serious amounts of money but does not yet have its product, team, and performance data clearly established. In recent years both early and later-stage money have been freely available.
Deflation of the unicorn bubble has the biggest impact on later stage capital flow. This is the money that entrepreneurs need to scale start-ups with demonstrated success and build them into mature companies. Later stage investors aim to profit from the spread between the value of late private rounds and the final exit value. A large part of the later-stage money comes from hedge funds and public/private crossover funds that can shift focus to other markets. This money has moved rapidly into venture investing as unicorn values have soared, and some of it may now move away.
But this is not all bad. Plentiful and easily-accessed money to scale later stage companies will be missed. But lower unicorn valuations are likely to make final exits come more quickly: acquirers will find marked-down unicorns more attractive, and the healthy pops in the share prices of Square and Match, which went public at valuations many perceived to be discounted, suggests that there is still a public market for these stocks, just at a lower price. Before the unicorn bubble, IPOs were growth financings as well as exits, and successful companies had 20x-100x value expansion post IPO (see chart below). That can happen again.
Money to start companies (“seed” funding) comes mostly from angel investors and seed funds. Inflows to seed funds have been strong in recent years, while the parade of unicorns was inflaming investor passions. But the linkage here is loose: seed and angel investing is also driven by supply of money, and this depends on exits that give investors liquid wealth and hence ability to make seed investments. Most unicorns are still private, not contributing to liquid investor wealth, so their deflation has little direct effect on seed funding availability. And, if the deflation accelerates final exits, that will put more money in seed investors’ pockets and increase the number of angels. The declining cost of starting a software company has also been a major driver of the seed investing boom; this continues. So unicorn deflation may dampen seed investing a bit, but it’s not likely to depress it severely.
What about that hard-to-find Series A and B money? As the chart shows, the volume of first time venture financings did not accelerate with the rise of the unicorns in the last 5 years; hence there is no correlation to suggest deceleration as unicorns decline. This money mostly comes from classic mid-sized venture funds. These funds have long established reputations, institutional limited partners, and 10-15 year investment cycles. Their capital flows are fundamentally less volatile than those of seed or late-stage investors. Corporate investors are also significant contributors in this market; their motivation is only partly financial and hence less linked to unicorn valuations. This money will remain hard-to-get, but probably not much harder than before.
That the best entrepreneurs thrive in the worst of times is part of the lore of venture. And we are far from the worst of times: people and real estate are ridiculously expensive in the Bay Area, employee turnover is high, and many investors and entrepreneurs are staying away. There is a lot of knock-off investing, too. Dialing down the hype and the hot money will help to clear the air in the venture world. Maybe it’s time to let the fields burn a bit so a new healthy crop can grow up?
