Below the fold, some discussion of these opposing views.
ProSteven J. Dubner's Is Venture Capital the Secret Sauce of the American Economy? is a positive view of the contribution of VC-funded companies to the overall US economy. It is based on research published in Synergizing Ventures by Ufuk Akcigit et al, who summarize it in Synergising ventures: The impact of venture capital-backed firms on the aggregate economy:
In a recent paper, we study both empirically and theoretically the role of venture capital (VC) funding – a key source of startup financing – in identifying promising startups and turning them into engines of growth (Akcigit et al. 2019). In particular, we examine the types of startups that get funded by venture capitalists, study the extent to which synergies between venture capitalists and startups and venture capitalist experience matter for firm growth and innovation, and evaluate how critical VC is for growth in the US economy.
To assess the magnitude of VC treatment effects, the selection of startups by venture capitalists must be taken into account. To control for selection based on observables, we match VC-funded firms with observationally similar non-funded firms along key dimensions, including year of initial funding, industry, state, age, and employment. Figure 5 plots the evolution of (ln) average employment for VC-funded firms and their matched counterparts over the period spanning three years prior to initial funding to 10 years afterwards. Among firms that patent, Figure 6 plots the evolution of (ln) citation-adjusted patent stock of VC-funded firms and their matched counterparts.
In both figures, the VC-funded and non-funded groups exhibit virtually identical trajectories before VC funding. However, subsequently VC-funded firms grow and innovate much more. Average employment increases by approximately 475% by the end of the horizon for VC-funded firms, whereas growth is much more modest for the control group (230%). Similarly, the average patent stock of VC-funded firms grows by about 1,100% over the 10-year horizon, as opposed to 440% for the control group. These results suggest that venture capitalists play an important role in the making of successful firms.It has long been known that there are many mediocre VCs and a few really good ones. Here, for example, is Bill Janeway's take:
let me just say one thing about venture capital that’s really different. It’s not the extremely skewed returns: we see that across various asset classes. Rather, it’s the persistence of a firm’s returns over several decades, as seen in the US and documented with the data provided not by venture capitalists themselves, but by their limited partners!
To understand a potential source of these treatment effects, we examine the heterogeneous impact on firm outcomes of being funded by more experienced versus less experienced venture capitalists. To do so, we first divide venture capitalists into two groups. Venture capitalists in the top decile of the ‘total deals’ distribution are labelled as “high quality” (high experience), and the remaining venture capitalists are labelled as “low quality” (low experience). Then, VC-funded firms are separated into those funded by high-quality versus low-quality venture capitalists. Figure 7 plots the evolution of (ln) average employment of firms in each of these categories, and Figure 8 plots the evolution of their (ln) average quality-adjusted patent stock.
While firms backed by high- and low-quality venture capitalists are similar prior to VC involvement, the average employment and average patent stock of startups funded by high-quality venture capitalists is higher after VC involvement, and the gap between the two groups widens over the 10-year horizon. By the end of the horizon, average employment grows by about 400% in the high-quality group, versus 320% in the low-quality group. Similarly, by the end of the horizon, the average patent stock grows nearly 50-fold for the high-quality group, and only 19-fold for the low-quality group. We confirm that startups funded by high-quality VCs have better employment outcomes through a regression analysis that controls for both startup characteristics and initial funding infusion. These findings suggest that factors beyond funding, such as expertise and management quality associated with high-quality venture capitalists, matter for subsequent firm outcomes.
YOUNG COMPANIES everywhere were preparing for doomsday in March 2020. Sequoia Capital, a large venture-capital (VC) firm, warned of Armageddon; others predicted a “Great Unwinding”. Airbnb and other startups trimmed their workforces in expectation of an economic bloodbath. Yet within months the gloom had lifted and a historic boom had begun. America unleashed huge stimulus; the dominance of tech firms increased as locked-down consumers spent even more of their time online. Many companies, including Airbnb, took advantage of the bullish mood by listing on the stockmarket. The market capitalisation of American VC-backed firms that went public last year amounted to a record $200bn; it is on course to reach $500bn in 2021.The money isn't just the result of previous successes by the VCs, it is coming from investors new to the space:
With their pockets full, investors are looking to bet on a new generation of firms. Global venture investment—which ranges from early “seed” funding for firms that are only just getting going to funding for more mature startups—is on track to hit an all-time high of $580bn this year, according to PitchBook, a data provider. That is nearly 50% more than was invested in 2020, and about 20 times that in 2002.
The frenzy is a result of both the entrance of new competitors and greater interest from end-investors. That in turn reflects the fall in interest rates across the rich world, which has pushed investors into riskier but higher-return markets. It has no doubt helped that VC was the highest-performing asset class globally over the past three years, and has performed on a par with bull runs in private equity and public stocks over the past decade.
End-investors who previously avoided VC are now getting involved. In addition to alluring returns, picking out the star funds may be easier for VC than for other types of investment: good performance tends to be more persistent, according to research in the Journal of Financial Economics published last year.
The rush of capital has pushed up prices. Venture activity for seed-stage startups today are close to those of series A deal sizes (for older companies that may already be generating revenue) a decade ago. The average amount of funding raised in a seed round for an American startup in 2021 is $3.3m, more than five times what it was in 2010The biggest VC firms, as usual, have outsized wallets:
The result is that the industry has become more unequal: although the average American VC’s assets under management rose from $220m in 2007 to $280m in 2020, that is skewed by a few big hitters. The median, which is less influenced by such outliers, fell from $70m to $48m. But this is not to say that the industry has become dominated by a few star funds. Market shares are still small. Tiger Global, for instance, led or co-led investments worldwide worth $5bn in 2020, just 1.3% of total venture funding.Note, for example, Andreeesen Horowitz' $2.2B fund devoted solely to cryptocurrency startups such as Chia.
Company founders, for their part, have gained bargaining power as investors compete. “There’s never been a better time to be an entrepreneur,” says Ali Partovi of Neo, a VC firm based in San Francisco.
The Economist notes that the proportion of startups exiting via the preferred route, an IPO, has increased:
The big-tech firms used to gobble up challengers: acquisitions by Amazon, Apple, Facebook, Google and Microsoft rose after 2000 and hit a peak of 74 in 2014. But they have fallen since, to around 60 a year in 2019 and 2020, perhaps owing to a fear of antitrust enforcement (see United States section). More startups are making it to public markets. Listings, rather than acquisitions or sales, now account for about 20% of “exits” by a startup, compared with about 5% five years ago.
ConFirst, note that although the rate of acquisitions by the FANGs has dropped, but only from 74 to around 60. On average, they are each buying a company a month. Second, note that acquisitions still outnumber listings by 4 to 1. Third, lets look at how well the companies that did list are doing.
|WSJ via Barry Ritholtz|
Looming behind a record-breaking run for IPOs in 2021 is a darker truth: After a selloff in high-growth stocks during the waning days of the year, two-thirds of the companies that went public in the U.S. this year are now trading below their IPO prices.Although the investors who bought in the IPOs are likely under water, the VCs who sold in the IPOs did well, As The Economist wrote:
With their pockets full, investors are looking to bet on a new generation of firms.The Wall Street Journal focuses on The $900 Billion Cash Pile Inflating Startup Valuations:
Investors are defying a share-price slump for newly public companies to make hundreds of billions of dollars available to startups, a cash pile that promises to inject a torrent of money into early-stage firms in 2022 and beyond.
|The South Sea Company Prospectus (1711)|
Special-purpose acquisition companies, which take startups public through mergers, raised about $12 billion in each of October and November, roughly doubling their clip from each of the previous three months, Dealogic data show. So far in December, three SPACs a day are being created. While that is below the first quarter’s record pace, it brings the total amount held by the hundreds of SPACs seeking private companies to take public in the next two years to roughly $160 billion.But most of it still comes from VCs, but with an increasing proportion from private-equity firms:
The cash committed to venture-capital firms and private-equity firms focused on rapidly growing companies but not yet spent also is ballooning. So-called dry powder hit about $440 billion for venture capitalists and roughly $310 billion for growth-focused PE firms earlier this month, according to Prequin.Just as the WSJ headline suggests, startup valuations have become inflated. In Seed Rounds At $100mm Post Money, Fred Wilson writes "We have been seeing quite a few seed rounds getting done in and around $100mm". He runs the numbers on a hypothetical $100M fund making 100 $1M seed round fundings each getting 1% of the company, for a $100M/company post-money valuation. There are three key parameters of his model:
- 2/3 dilution from seed to exit, so the fund ends up at exit with only 0.3% of the company.
- A 0.75 power-law of returns among the 100 companies, as shown in the graph.
- The best performing among the companies exits at a $10B valuation.
a $100mm seed fund that makes all of its investments at $100mm post-money will barely return the fund. And that number is gross, before fees and carry.The fund put in $1M and got out $1.333M. That isn't a viable VC fund. Wilson points out that the valuation is the problem:
f you run that same model with a $20mm post-money value, you get a 6.667x fund before fees and carry. That’s a strong seed fund, probably a tad better than 4x to the LPs, after fees and carry. If you think you can get one of your hundred seed investments to a $10bn outcome, then paying $20mm post-money in seed rounds seems to make a lot of sense.But Joseph Flaherty tweets that $10B valuations are rare:
Some historical context on @fredwilson's latest.— Flaherty.eth (@josephflaherty) November 15, 2021
Between 1/1/2010 - 12/31/2019, 166 tech startups went public.
Here's where their valuations sit now:
2 = $1T+ (TSLA/FB)
4 = $100B+ (SHOP/NOW/TEAM/SQ)
48 = $10B+
35 = <$1B
Median = $4.4B
It is important to note that the data underlying Ufuk Akcigit et al's analysis is entirely from the period before the most recent tsunami of money hit startups. It largely reflects the VC ecosystem back in the days when I worked at startups, with the balance of power in favor of the VCs. They write:
The analysis is carried out by combining data on all employer businesses in the US from the Census Bureau’s Longitudinal Business Database (LBD), with data on patenting from the USPTO, and deal-level data on firms receiving VC funding from VentureXpert for the period 1980-2012. A key advantage of the data is that it enables us to track the evolution of employment and patenting for all employer businesses in the US, and, critically, differentiate between the experience of VC-funded firms and other firms in the economy.The current balance of power is in favor of founders like Travis Kalanick, Adam Neumann, Justin Zhu, and Elizabeth Holmes. The Economist notes this change:
The shift has also weakened governance. As the balance of power tilts away from them, VCs get fewer board seats and shares are structured so that founders retain voting power. Founders who make poor chief executives—such as Travis Kalanick, the former boss of Uber, a ride-hailing firm—can hang on for longer than they should.What Akcigit et al don't investigate is the extent to which their earlier results, showing the beneficial effects of VC funding, are due not to the overall effect of VC funding, but to the large effect of high-quality VC funding on a small proportion of the funded companies. Nor do they investigate whether the effect of the more recent flood of money, the resulting proliferation of VCs, and the shift in the balance of power toward founders, has resulted in the small proportion of companies funded by high-quality VCs has become even smaller, thus dragging down the aggregate benefit of VC funding to the economy.
As I wrote in Venture Capital Isn't Working:
I'm a big believer in Bill Joy's Law of Startups — "success is inversely proportional to the amount of money you have". Too much money allows hard decisions to be put off. Taking hard decisions promptly is key to "fail fast"."Fail fast" used to be the mantra in Silicon Valley. In most of the world success was great, failure was bad, not doing either was OK. In Silicon Valley success was great, failure was OK, and not doing either was a big problem. Trying something and failing fast meant that you had avoided wasting a lot of money and time on an idea that wasn't great, and you had freed up money and time to try something else. Now the mantra seems to be "fake it till you make it", which pretty much guarantees a waste of time and money.