Fundraising surge fueling questionable valuations

Venture capital firms are raising so much money that it is fueling an overfunding of companies.

Some 259 U.S. venture capital funds amassed $46.3 billion in 2019, the second highest by amount of capital raised and the number of funds since 2006, according to the PitchBook-NVCA Venture Monitor. The biggest fundraising year since 2006 was 2018, when 299 venture capital funds raised $58 billion.

With all of that capital, some venture capital firms have been hunting for potential unicorns, companies worth $1 billion or more. Investing in the next $1 billion-plus unicorn has become a badge of honor and marketing tool, and the massive amounts of capital pouring into the asset class is fueling a lack of discipline and a recent drop in the number of exits as companies struggle to match their optimistic valuations, industry insiders say.

"There's a desire to attain a $1 billion valuation ... whatever the round number is," and these venture capital firm executives are stretching to get there, said Ed Zimmerman, New York-based partner and head of the technology group at law firm Lowenstein Sandler LLP.

This "lack of discipline," mainly in late-stage investment, he said, has led to an increase in so-called vanity valuations, portfolio company valuations that are larger than may be justified by the company's performance, he said.

According to the PitchBook-NVCA report released Jan. 14, there were 237 megadeals in 2019, transactions worth $100 million or more, that were valued at a combined $59.5 billion, fewer than in 2018 but the second highest on record. More of these megadeals were for new, early stage companies, with 22% of the deals being early stage mega transactions in 2019, the PitchBook-NVCA data shows. The lion's share of the megadeals, 76%, were for older, late-stage companies. Five year's earlier, 10.7% of the megadeals were early stage companies with the percentage on a jagged upward trajectory since then.

These valuations are not supported by the by recent transactions of comparable companies or by any other metric, Mr. Zimmerman said.

Due to the abundance of capital raised by venture capital and growth equity funds, money is being spent by some managers based on the need to deploy capital, Mr. Zimmerman said.

Compounding the situation is the historic opacity of the venture capital and startup market, he said.

"There's no disclosure of performance until a company is public," he said. "People in the loop will get varying degrees of information and information can be very powerful."

Some industry insiders say these vanity valuations are making it more difficult for venture capital firms to exit because not all of the companies are able to sell or go public at those high valuations, he said.

Indeed, exits are down. Venture capital firms had fewer exits in 2019, dropping 13% to 882 worth a combined $256.4 billion even as the dollar value of exit transactions nearly doubled. By comparison, there were 1,015 exits totaling $130.2 billion in 2018, the PitchBook-NVCA report shows.

"Valuations are aggressive in the venture capital and growth (equity) space in my opinion," due to the amount of capital from various sources chasing growth, said Jared Barlow, Greenwich, Conn.-based managing partner at private equity secondary market manager Kline Hill Partners LP.

Non-traditional investors are increasingly investing in venture capital and growth equity transactions. Non-traditional investors, such as sovereign wealth funds and family offices, participated in 85% of the megadeals in 2019, the PitchBook-NVCA report indicated.

It's possible that a company could grow into its aggressive valuation. But Mr. Barlow said the percentage of companies that have grown into their valuations "is almost a coin flip, 50/50."

However, if the company valuation is high based on the last round of venture capital investment, but the company's performance since then has been "underwhelming," a secondary or other potential buyer could heavily discount the investment, Mr. Barlow said.

"The seller may not want to sell at a discount. It's harder to convince themselves and their organization that they should take that big of a haircut," he said.

In 2019, there was an increased focus by some investors on companies that were "burning less cash and trending toward profitability," Mr. Barlow said.

There's a little bit of a flight to quality with investors seeking companies that have a path to profitability, he said.

"My view is that investors are better off with companies that can be resilient in case of an environment with less liquidity and a more difficult climate for companies that are reliant on the next funding wave," Mr. Barlow said.

Investors have been moving into venture capital as a way to gain exposure to the technology companies that are disrupting industries or will be doing so in the future, boosting portfolio company valuations.

"Technology is becoming more ingrained in our everyday lives," said Aaron Miller, Wilton, Conn.-based managing director in charge of venture capital for fund-of-funds manager Commonfund Capital Inc. "Leading technology companies are becoming household names."

Technology is transforming industries previously untouched by disruptive technological advances such as logistics and health care, he said. This is leading to investor interest and higher portfolio company valuations, Mr. Miller said.

"We do believe there is an elevated valuation environment across … venture capital, especially later-stage venture capital," he said.

Commonfund Capital focuses on investing with early stage venture capital firms, he added. Over the past 10 years, late-stage venture capital values have grown 15% year-over-year, while early stage transactions have grown 9% per year.

In early stage deals, price is less of a concern than the amount of ownership a venture capital firm manages to acquire, Mr. Miller said. Early stage venture capital firms look to acquire a 15%-to-20% ownership at a reasonable valuation, he added.

"Later-stage companies are priced to perfection. There's not a lot of value" to be gained on exit, Mr. Miller said.

Tony Ialeggio, a managing director and chief marketing officer at Commonfund Capital, said that firm executives "have seen exits at the last valuation or less."

However, with several big name companies including WeWork Cos. Inc. suffering pre-IPO valuation declines compared to their valuations after their last round of venture capital financing, some venture capital firms are starting to pull back from the higher valuations, Mr. Miller said. WeWork's valuation fell to $7.8 billion from a high of $47 billion in 2019.

It's not as easy to get venture capital financings for good late-stage companies now as it was six months ago, Mr. Miller said. Some venture capital firms are starting to invest more money in fewer portfolio companies, leading to fewer late rounds of investments, he said.

This has not had a meaningful impact on early stage valuations yet, Mr. Miller said.

"It takes six months to 12 months for (company valuation issues) to trickle from the public markets to the private markets," he said.

Even so, there is an abundance of capital for early stage companies, leading to a competitive market.

"The early-stage funds generally have carrying values at a discount to the high-priced, headline-grabbing, later-stage financings that we all read about," said Scott Voss, Boston-based managing director of alternative investment fund-of-funds and secondary market firm HarbourVest Partners.

Venture capital funds that invest early in a company's journey generally invest at much lower valuations than later-stage funds, he said.

Generally, early stage venture capital invests at a cheaper price, commonly at discounts of 20% to 40% below the value of the company when the later-stage venture capital firm invested in the company, Mr. Voss said.

"Also, once the (venture capital-backed) companies are public there is also typically a discount applied to the true public market value. That discount is usually 20%," he said.