While U.S. Startups Barometer remains bullish on VC market, concerns exist about startup pipeline

Bloomberg’s U.S. Startups Barometer for August 21, 2017 highlights an environment ripe for startups to attract venture capital (VC). The weekly index tracks the overall health of the business environment for private technology companies based in the U.S. Driven by the number of VC financing deals, the barometer set a new record high for the second consecutive week with a nearly 65 percent increase from last year’s index score.

While the barometer paints a bright future for startups, there are several other issues regarding the fundamentals of VC market that are more concerning including: a lack of early stage startup capital creating potential pipeline issues; the dearth of successful exits/IPOs by VC-backed startups; and, heavily capitalized mega funds with significant dry power.

While optimism in the VC market has been driven by promising news regarding mega-rounds of investments and significant fund raising, there is  concern about the fundamental underpinnings of the VC market due to a decline in the number of early stage deals (as compared to last year) as well as a significant decline in seed stage deals since Q1 of 2015. As VCs have focused on mega-rounds (deals of $100 million or more) in late stage companies, early stage companies have struggled to access the capital necessary to move them through the pipeline. 

This has the potential to create a long-term issue: where will the next generation of unicorns and other growth-stage companies come from? With startups already facing long-odds of reaching maturity, there could be a dearth of firms that are worthy of future rounds of growth-stage funding. This pipeline concern is a development that needs to be monitored over the next few years.

Another concern for the VC market is the lack of successful IPOs and exists. While many VC-backed firms (e.g., Blue Apron, Snapchat) received significant hype before their IPOs, their success has been extremely mixed. For example, Blue Apron’s stock value has fallen by nearly 50 percent since it became public. Snapchat’s value has dropped by nearly 20 percent.

Driven by high valuations and external pressures/stresses, some of the most anticipated VC-backed IPOs have struggled to create a significant return – as compared to their last round of investment. The long-term concern for VCs will be what happens if unicorns (those valued at $1 billion or more) and other VC-backed companies decided to eschew the IPO route.

If these companies choose to remain private due to fears of a failed IPO, the VC dollars will remained tied up in these companies. This creates a huge opportunity cost for VCs that must hold off making first round investments in early stage startups.

While there should be concerns over a mixed IPO market, Isabel Gottlieb, from Bloomberg Technology, highlights that exits, which are down 29 percent from last year,  are a more significant concern. Similar to IPOs, this creates a future pipeline issue because VC dollars are tied up in late stage companies instead of being invested in new high-growth potential companies. Pitchbook found private companies are taking nearly six years to exit after their first round of VC-backing – nearly a year longer than the average for VC-backed companies a decade ago.

The Chicago Tribune’s Sarah McBride describes the potential fallout of frozen VC markets for early stage companies. After a surge in early stage VC investments in 2014/2015, McBride points out that many startups are struggling to raise second and third rounds. This lack of capital is leading to more startup deaths. She attributes this lack of startup capital to higher expectations for milestones for early stage startups.

While startups struggle to access capital, VCs have been consistently setting fund raising records. Driven mostly by large investments in mega funds, the overall VC market has a significant amount of dry powder (fund-raised dollars that are not being invested). Proponents contend that this due to more realistic valuations. However, these nearly unachievable milestones for startups to attract VC backing may actually be driving the significant buildup of dry power.

As large institutional investors have driven the VC market to record high in capitalization, the long-run concern is that a bubble may form if strong ROIs (returns on investments) are not realized. After the 2008 collapse, many investors have flocked to the VC market because of perceived ROIs. These perceived ROIs, however, rarely have come to fruition with most VCs barely outperforming other investment vehicles (e.g., stocks, bonds, real estate).

This buildup of dry power coupled with tighter VC markets may be creating a powder keg situation that could be lit by investor impatient/demands. With IPOs/exits declining and higher milestones for early stage startups, the fundamental concern is that a large number of investors will not actualize their intended ROIs and withdraw their money from the market. If this occurs, there is the potential for a bubble to occur and burst.

To avert a crisis, the overall VC market will need to see an unthawing of early stage and seed stage markets as well as a higher number of successful IPOs/exits by VC-backed companies. However, if VCs (especially the mega-funds) continue to chase these large, hard-to-achieve, unicorn-driven mega-ROIs, the long-run outlook does not look bright.