Despite the recent falls in the value of some unicorns, there are still startups that are worth investing in.
Keeping abreast of news and market developments is a critical part of a venture capital investor’s job. We always need to be scanning for opportunity and risk; the market intelligence we can garner is a key asset. It has been fascinating over the past couple years to watch sentiment visibly change before our eyes. We watched it in the spring of 2020 when financial markets were spooked by the first lockdown.
We watched it again that same summer as the “Covid beneficiaries” began to surge. Ocado doubled its market cap through March, April, May 2020. Between March and December 2020, Peloton went up 8x (!). However, take a look at the price charts now for any of these companies (Netflix, Shopify, Zoom, Deliveroo… the list goes on) and you will see that they have all returned to share prices that approximate their position in Q1 2020, pre-pandemic.
We have just watched (and may still be watching) another major move in this respect. So as far as the public markets are concerned, Covid has little bearing now on the market outlook. It almost appears as if it never happened, from a financial point of view, and to some extent that is how it should be. The price of a share should reflect its future, not its past.
The reversion to 2019 levels in public markets spills over into private market valuations, particularly at the later stage, which might suggest that we are returning to a stable status quo ante.
However, that isn’t the case. Markets and opportunities are dynamic, and we expect that some of the changes we have seen over the past couple of years will be lasting. Not all will, but certainly some. Hybrid working, the acceleration of digital healthcare and adoption of new software as a service (SaaS) platforms are all examples of direct effects that look like they will stand the test of time.
Innovation waves
What is more, they continue to be complemented by waves of innovation in the fields of finance and sustainability that pre-date the pandemic and recent market turbulence, while being challenged by new conditions: conflict, inflation, supply chain pressure and more.
In that context, the opportunities still abound for venture capital investors. While it is generally true that an environment of modest inflation is healthier than one of rapid rises, it does not mean that investment will stop. It means that focus and tactics will need to change.
Confidence is likely to be impacted as we move from a market with strong valuations, less challenging fundraising for most and a forgiving operating environment – but venture capital strategies also fare well in a downswing. Early-stage investors are seeking to identify and invest in companies with outstanding entrepreneurial teams with unique or ground-breaking products that aim to create or re-fashion large markets. All of that is possible in a downswing and in this part of the cycle conditions may even be improving for startups. Mobility of, and competition for, talent may reduce. Expectations of very rapid growth may be deprioritised in favour of stable product and technical foundations. Relative scarcity of capital may mean that businesses need to be leaner by default. All of these things factors could be positive for early-stage investment.
With primary investments, we are still looking for that same killer team/product/market combination. Early funding rounds may be smaller than they have been as investors hesitate to commit but this part of the market is often characterised by “milestone-based” investing. This is different from the paradigm we have been in where some investors have been chasing scale with excess capital – trying to use money to force growth and take market share, often at the expense of financial discipline.
A disciplined approach is more important than ever now and “runway” and “cash burn” need laser focus in a market where follow-on funding is likely to be relatively scarce. The traditional venture capital model uses a follow-on investment strategy, but in recent years we’ve seen investors sacrifice terms, influence and, in some cases, good sense just to get a seat at the table. We think that approach will turn out to have been an anomaly. Venture capital investing is involves patience, experience and a degree of craftsmanship. When those things fall by the wayside, it becomes speculation.
What really matters
Recently, companies have been vying for the crown of “fastest unicorn” or biggest valuation uplift and recent months have highlighted that these are vanity metrics. For investors in VC funds, what matters is not how quickly a company can develop a “unicorn” valuation but whether it can get there, sustain and grow that valuation and, of course, exit at that valuation.
Secondaries strategies, as opposed to primaries, have the benefit of being relevant at all points in the cycle, thought they work best where capital is scarcer and timelines to exit may be extended. The belief behind this product is that the ability to provide interim liquidity is important for the health of the ecosystem.
Management soap opera and missed expectations make for good stories but most growth companies have not gone from good to bad overnight. There remains a huge and growing cohort of quality businesses and exceptional opportunities whatever the weather. Most venture capital funds invest into a 10-year horizon and when we look at the bigger picture we expect to continue to find and finance many companies whose technology and products are making the experience of life and work better for millions of people.
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