Looking Forward: VC trends to watch in 2018

With the 2017 data in the books (see our analysis of MoneyTree and useful stats from the Venture Monitor), we can take a more informed look at the prospects for the industry in 2018. We identify four trends — increasing exits, massive deals, accumulating capital and improved diversity — that may shape the overall VC industry in 2018 and why they could make a difference for regional innovation initiatives.

Increase in the number of startups exiting

The number of exits has decreased for 11 straight quarters, according to the Venture Monitor, but 2018 is likely to see increases in both initial public offerings (IPOs) and merger and acquisition (M&A) activity.

Why it matters: For funds experiencing longer-than-anticipated lifecycles, potential opportunities to experience exits may be a welcome opportunity to recapitalize and reinvest in the region. Organizations focused on maintaining homegrown companies will want to be wary of acquisitions that may necessitate relocations or eliminations for local jobs.

What is behind the trend: While simple probability suggests that after a long decline, an increase in exits is likely to occur at some point, there are structural reasons to believe 2018 will see the start of this turnaround. The completion of federal tax reform provides a money-saving opportunity relative to last year for some investors, and the anticipation of this moment may have been deflating the market in 2017. The tax bill is also effectively providing some companies additional capital that may be used for M&A activity. There are plenty of reasons to question what portion of funds will be used for this purpose — Apple has announced plans to invest just $30 billion of the $245 billion it is repatriating — but some of the anticipated earnings boosts will happen in capital- and innovation-intensive industries, which include companies like AT&T, Exxon Mobil and Pfizer. Certainly, the extended lifecycle of the average venture-backed company will have left many founders and early investors hopeful for exit opportunities in the near future.

Massive deals continue to skew perceptions of market

Thanks in part to a record number of deals investing more than $100 million at a time, 2017’s VC overall trends were heavily influenced by outliers at the top, and this activity is unlikely to change in 2018.

Why it matters: Regions seeking to attract new investors to participate in deals may find that media emphasis on massive deals and companies are creating unrealistic expectations for the stage and size of regional companies’ needs. Such perception must be broken down as part of the education and recruitment process to set realistic expectations and attract investors to the market.

What is behind the trend: Much of the reporting on the VC market in 2017 emphasized massive fundraising and investment (see SSTI’s coverage of mega rounds and bullish markets). One player is of particular note: SoftBank was involved in deals representing nearly one-tenth of the VC market by dollars and has demonstrated a potential to help its investments achieve economies of scale — such as the acquisition of its Brazilian ridesharing company by its Chinese ridesharing company. The market-shaping opportunities presented by this type of scale are in reach for many other corporate investors.

Massive deals were not limited to SoftBank, however. According to PitchBook’s platform, the 10 largest deals of the year accounted for 23 percent of all dollars invested. Removing just these deals from the total of 8,076 deals last year reduces 2017’s average deal size by more than $2 million. A moderate upswing in exit activity is unlikely to completely restore the market to the norms of three or four years ago, and so this skewing effect seems unlikely to abate in 2018.

Capital continues to stockpile with funds

VC firms had another easy year of fundraising in 2017, and lower tax rates combined with coverage from potential exits suggests fundraising will continue to boom through 2018.

Why it matters: A core challenge for regional innovation economies in much of the country is how to get capital off the sidelines and into local startups. If many investment firms are struggling to identify enough investments to provide their investors with a return, then this failure presents a pitch opportunity for funds outside of the major markets that are driving this trend. 

What is behind the trend: Through the third quarter of 2017, the Venture Monitor was reporting a record $90 billion in uninvested capital, or “dry powder.” Fundraising activity did slow in the second half of 2017, but the year still finished with more than $32 billion in new capital committed. Attracting these commitments is proving easier, as average funds closed larger and more quickly than in the past.

Capital is accumulating for a variety of reasons. Investment in early stage companies is decreasing for reasons that are not obvious. One explanation may be found in a parallel to the lending behavior of larger banks — larger funds are preferring to move upstream as a way to make more efficient use of their size and time. A second reason for capital accumulation in VC is that yields in some alternative investment markets, such as bonds, remain low. Increases in interest rates by the Federal Reserve, which are likely in 2018, may help restore the attractiveness of other markets and draw some capital away from VC commitments. The accumulation of capital may slow relative to 2017’s historic levels, but short of a massive increase in deal activity, VC funds are likely to finish 2018 with tens of billions of dollars in untapped capital.

Diversity in VC finally achieves traction

Rates of investment in diverse founders have barely changed in the past several years, but the combination of increased public attention to gender equality and the buildup of uninvested capital could begin to drive a change in 2018.

Why it matters: By definition, regional efforts are concerned with improving the geographic distribution of investment capital and should be actively following any trends that may yield changes. On the issue of founder diversity, publicly-supported initiatives to strengthen regional innovation economies should be available to all people in the region, and private market acceptance of inclusion would be helpful in this mission.

What is behind the trend: A core potential driver of this trend is the unbalanced current structure of the VC market. VC firms are sitting on billions in uninvested capital but continue to invest relatively exclusively in firms established in just three states by males who are white or Asian. Considering that the number of these startups receiving investments is declining, that diverse firms have better average financial returns, and that more than three states support large numbers of successful companies, this is basic evidence of a market inefficiency. At some point, the VC market at large should realize this lost economic opportunity and make an adjustment.

Could 2018 be the year this changes? A number of funds targeting these underserved founders have already been established. Increasing public attention to sexism across many areas of life has not escaped the VC industry, which may help prompt firms to reconsider their investment decision-making. High-profile initiatives in the middle of the country, such as the Rise of the Rest, may also help investors interested in garnering attention decide to take a better look at firms outside of California, Massachusetts and New York. Change tends to happen slowly, and large effects may not occur in 2018, but, hopefully, the industry could move toward a tipping point.