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Latest VC reports continue 2017’s Rorschach test

October 26, 2017
By: Jason Rittenberg

Two 2017 Q3 venture capital market updates are not providing much clarity on the underlying state of the industry. Data on greater uninvested capital, larger deals and fewer exits, among other indicators, suggest that venture capital is in need of a market correction. At the same time, new fundraising, a move toward wider geographic distribution and the rise of alternative financial structures could speak toward the emergence of a more sophisticated market. In the absence of decisive indicators, the data allow for any number of explanations and predictions. This week, we are exploring the deals data, and next week, we will look at funds.

Deal characteristics

The National Venture Capital Association/PitchBook Venture Monitor and the PricewaterhouseCoopers/CB Insights MoneyTree reports both find steady deal flow in Q3 (see the datasheet accompanying this article). Venture Monitor finds $21.5 billion invested across 1,705 deals during the quarter, while MoneyTree, which does not cover as much of the early stage market, finds $19.9 billion across 1,285 deals. If these trends continue in Q4, 2017 will see fewer deals but more money than recent years.

Both reports identify that 2017 deals-to-date are located across a slightly broader geographic base compared against 2016. In Venture Monitor, California, New York and Massachusetts account for 52 percent of the quarter’s deals. MoneyTree finds these three states to be 63 percent of all deals and 73 percent of invested dollars, which indicates more diversity among early-stage investments than VC deals. If this trend continues in Q4, 2017 will see more, particularly early-stage deals, in a broader range of states than in other recent years.

Deal size is on the rise in 2017, which is set to be the third straight year in which 60 percent of all U.S. deals invest $25 million or more. Through Q3, 2017 is on pace for an average VC deal size of $11 million, per Venture Monitor.

Much of the increase in deal size appears due to the increasing dominance — and skewing — of the market by unicorns. According to PitchBook, companies with valuation greater than $1 billion account for more than one-fifth of all invested capital this year. MoneyTree and analysts point out that unicorns are increasingly born overseas, particularly in China. As investors increasingly seek larger deals and overseas investors become more active, early-stage investment policy may soon become a significant international concern.

Exits and aging

Unicorns are also emblematic of the market’s trend toward an increasingly long path to exit. PitchBook recently covered U.S.-based unicorns’ age, which is approaching an average of nine years, up by nearly four years from 2012. Whether this stagnation is due more to a positive strategic choice or difficulties in going public is unclear. Unicorns have had no issues raising funds through additional rounds, and given that these companies and their investors may have significant concerns about current valuations and IPO performance, private markets may be the safest option.

The exit challenge is not limited to unicorns, however. The average company has seen its time to exit rise by one year to 6.2 years since 2012, and time is likely to continue increasing as Q3 saw the fewest total number of exits since 2009, yielding 11.2 investments for every exit during the quarter. Just eight companies went public in Q3, while TechCrunch reports just one multi-billion-dollar acquisition to date in 2017.

The lack of exits is creating a liquidity challenge for startup employees and early investors, which is giving rise to alternative exit structures. PitchBook records $5.2 billion in private equity buyouts so far in 2017, the most the company has recorded, prompting a report outlining the opportunities and challenges for a VC secondary market. Social Capital launched a public holding company and then purchased a startup as an end-around to a traditional IPO; SoftBank’s $100 billion fund is reportedly behaving at least partially like an equity fund and buying some companies that are struggling to raise later rounds.

Whether the rise of alternative financial instruments is a positive development is not obvious. A collateralized debt obligation (CDO) was a financial structure building upon the mortgage industry’s normal functioning to “solve” the problem of too many low-quality loans. CDOs served a market need at the time but helped grow a bubble that may have popped earlier with fewer repercussions in their absence. In providing an alternative form of exit for companies, employees and investors, are VC buyout funds providing a necessary and healthy function, or are they helping to propel companies that might otherwise pivot, fold or seek acquisition to higher and less-sustainable valuations?

Ultimately, startup quality and investor behavior are the core drivers of the market’s health. The Q3 data indicates trends toward larger deals going into older companies, which may mean investors can access more information when making these decisions and are able to effectively judge the opportunities for the companies.

Next week, we will look at fund data that will help shed further light on investor behavior and the current state of the VC market.

venture capitalFile VCQ317.xlsx