Has the tide turned for the US venture industry?
The 2Q 2017 PitchBook-NVCA Venture Monitor evaluates recent trends, from the upswing in deal volume and value to the effects of ongoing disparity between investments and exits. Specific data cuts include activity by stage and region, as well as features on corporate VC, growth equity, exits and fundraising.
Report highlights:
- Late-stage deal count is up 20% since 4Q 2016
- Exits are in a crunch: 2Q transactions fell to the lowest figure since 2011
- Riding the coattails of 2016's record fundraising, VC vehicles receive more than $19 billion in commitments through June
Executive Summary
US venture investment activity is firmly in the middle of a self-correction period. Signs of this normalization began in the second half of 2016 after investment levels peaked between 2014 and early 2016. While on the surface this leveling off, particularly at the early stage, may give pause to some, those immersed in the industry on a day-to-day basis welcome this news as a healthy return to steadier investment after several years of froth. With valuations subsiding, the industry is witnessing a back-to-the-future moment to some degree as trendlines point toward a healthy venture ecosystem.
In the first half of 2017, 3,876 venture-backed companies raised $37.76 billion in funding, with $21.78 billion deployed to 1,958 companies in the second quarter alone. 2Q marked an uptick from 1Q totals in terms of capital raised, though the overall number of companies receiving investment remained relatively stable. The divergence stems from the high number of mega-financings that happened during the quarter. The top 10 deals alone accounted for $4.3 billion in deal value, representing 19.6% of total dollars invested during the quarter, and 34 financings were completed of at least $100 million. While there have been fewer deals across all stages of investment, the decline has been the most acute at the angel and seed stage, which has also correlated to a drop in first-time funding rounds. Many venture investors are seeing this first-hand, as they report that most of the promising companies they have recently evaluated have been at the Series B, C, and D stages and fewer at the angel, seed, and Series A stages, likely an effect of the influx of companies at the early stage that received funding in 2015 and 2016.
Looking ahead, capital invested is unlikely to drop off given that venture funds have raised $130 billion since 2014. Investors are mindful of approaching the five-year window in which deploying capital is a priority given the venture fund life cycle. While overall 2017 venture fundraising is off pace slightly from 2016 in terms of closed vehicles, first-time fundraising has been a bright spot. 15 first-time funds have closed on a combined $1.5 billion, on pace for the highest annual capital raised in the past decade.
While investors balance deploying recently raised capital, their existing portfolio companies continue to grow and scale, and exit paths remain top of mind. After a slow start this year, the IPO market for venture-backed companies picked up steam in 2Q, bringing the 1H total to 27. There’s optimism of a strong year ahead for venture-backed IPO activity on the heels of five unicorn IPOs through 2Q and a strong pipeline of companies in the registration process, including real estate platform Redfin and security provider ForesScout, which has reportedly filed confidentially. The performance of offerings has been mixed, notably with Cloudera’s IPO valued lower than its last private funding round, a move that other companies are closely monitoring to see the market’s reaction.
Against the backdrop of a vibrant venture ecosystem in 2017, policymakers have found themselves still adjusting to the new Trump Administration. Several public policy areas of interest for venture investors and their portfolio companies—many of which were topics of discussion at the NVCA Annual Meeting in May—continue to make headlines and face major hurdles in the coming months. Specifically, we are still waiting to see if the Trump Administration will allow for the International Entrepreneur Rule to go into effect on July 17. Continuing conversations around tax reform offers opportunities to highlight the importance and positive impact of investment into high-growth companies—which reached 45 states and the District of Columbia, and 145 Metropolitan Statistical Areas in 2Q—to policymakers remains a priority for leaders in the venture industry.
Overview
We have previously mentioned our expectation of deal flow to stabilize, and the plateau that is in its early stages may be the culmination of the overall drawdown of the venture cycle. For the second consecutive quarter, aggregate deal count increased, even if only slightly. Completed rounds across each stage are almost evenly split between 1Q and 2Q, the only distinct difference between the two being the aggregate value of each quarter—2Q saw 34 transactions of at least $100 million in value, while 1Q totaled just 12 such transactions. Further, completed late-stage deals in 2Q (441) came in 25% higher than in 3Q 2016 (354), which had been the low-water-mark since the end of 2009.
Median round values continue to grow across all stages. Both the median early stage and late-stage round sizes have reached the highest point in the past decade. 2017 is on pace for the largest number of rounds of at least $50 million during that timespan, and growth equity rounds provided nearly $11 billion in capital to companies in 2Q alone. Since 2014, the 10 largest rounds during each year have a combined value of just over $33 billion. That is, just .01% of deals during that time have accounted for 13% of the capital invested over the last three and a half years. The increases are caused by several factors, but are in large part due to the strong fundraising environment that has produced more than $129 billion in commitments since 2014. With the record amount of dry powder, round sizes will likely continue to grow, though at a more tempered pace. Alongside increased fundraising, startups are taking longer to work through each stage as investors have stressed capital efficiency and reducing burn rates to a manageable level. The longer runway provided by larger rounds enables startups to grow sustainably as well, helping to reach higher and more robust performance metrics that investors are looking for.
An area that could become a bit concerning to investors is the investment-to-exit ratio, which has reached the highest point we have tracked. Late-stage companies have increasingly chosen to continue raising private capital rather than move forward with an exit. While it may not generate negative consequences, the prolonged hold time increases the risk for all investors involved. As corporates move quickly to innovate, missing an opportunity to exit could be dangerous.
As companies stay private longer and more capital is invested, questions are being raised over the efficiency with which capital has been deployed. More than $1 billion was invested in Cloudera prior to its recent IPO, with investors holding roughly 57% of the equity. With a total hold period of around eight years, the IPO valuation of less than $2 billion didn’t create the return on investment many investors were hoping for. This argument has also driven conversation around regions and MSAs within the US. In the chart below, we scored each US region by considering the value created at the time of exit for each company since 2006, then factoring in the aggregate amount of capital those companies raised over time, as well as average time to exit.
Moving forward, the ability to create and realize value quickly will be an even larger differentiating factor for VC managers. As exit timelines push out, more traditional fund lifecycles are also being impacted. The ability to invest and wind down a fund in the classic 10-year time frame is becoming more difficult, challenging the fundamentals of the venture industry and creating even more risk for LPs from the illiquidity and market risks inherent to a longer fund life.
Angel & seed investment at a plateau
Angel & seed activity in the US
The angel & seed stage has seen consecutive declines for eight quarters, falling by nearly half during that time. The problem is not necessarily a diminishing of entrepreneurship in the US, but a systemic change in how the earliest-stage startups approach growth challenges. For one, more and more companies are emerging from out of an accelerator with cash and a more developed business model. A large portion of 2014 and 2015 figures were created through second and even third angel or seed rounds, where today those aren’t as needed. The emergence of cloud services, such as Amazon Web Services, has made it possible to start and grow a company with less capital, allowing it to be bootstrapped for some time—or operating off of a lower amount of raised capital and any operating income for a much longer duration than say even five years ago.
The run-up to 2015’s high figure was also a product of the high number of seed-focused funds raised in the years before. Many of those funds have not been able to raise follow-on funds, either because their investments didn’t pan out, or because their returns have yet to be realized and consequently LPs aren’t willing to reinvest.
Early-stage deals continue along at steady rate
US early-stage VC activity
Despite the high value accrued across early-stage deals during 1H ($10.3 billion), raising such rounds has become much more difficult. Investors have chosen to invest higher amounts in fewer companies, rather than amass a larger portfolio across several smaller deals. Completed early-stage deals have declined 22% in the past two years while the median round size has increased almost 40% in that same time. As earlystage investing moves further into the startup lifecycle, larger deals are helping companies attract top talent to further growth initiatives. It also provides a longer capital runway to allow for more sustainable growth, emphasizing revenues and operating efficiencies to accompany with scale and user growth. VCs understand that benchmarks for follow-on rounds are getting more stringent, and providing startups with longer runway to reach them while also building a competitive well-run business benefits both sides of the table.
As the startup lifecycle continues to evolve, investors will need to continue to adapt accordingly, as well. 2016 was a record year for rounds of at least $10 million at the early stage. The 687 completed investments of that size were well more than double the total in 2010 (309), and this year is on pace to surpass last year as 371 have been completed through 1H.
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