Where does VC go from here?

At the height of the market last summer, I got a call from two first-time entrepreneurs. Their company had less than $5 million in annual revenue, yet they were raising at a billion-dollar valuation. As an entrepreneur myself, I get how hard it is to build a new business from nothing, and wanted to support them in their journey – but I had to pass at $1 billion. Even though there were numerous deals getting done with similarly sized companies, it seemed silly. Three weeks later, I learned that they’d been funded at that valuation.??

There’s no denying that many entrepreneurs have developed an unhealthy obsession with valuations. The unicorn. The decacorn. The dragon.??

There are now over 1,200 unicorn companies. To put that in context, only 159 companies went public in 2019. This year that number may be close to zero.

This valuation obsession has become woven into the fabric of the entire tech industry, from founders to investors to employees to the media. Inspired by the evolution stories of today’s biggest tech giants, we’ve created an entire industry on the belief that with a good idea and the power of tech anyone can launch the next billion-dollar company out of their garage.?

Don’t get me wrong - the power of imagination and optimism is an amazing and essential part of innovation. But over the years, we’ve become so enamored with the unicorn valuation as the goal, that we started valuing the wrong things and overlooking the fundamental physics of business.?

With capital at zero cost, growth at all costs became the mantra. How fast can you grow? How big can you get? How quickly can you scale? How much can you raise? How many users do you have? Hyper-growth became the gold standard and we lost sight of building durable and valuable companies for the long term. Profitability was a dirty word. The entire industry agreed just to worry about profitability later - just invest in the business and it will come.?

Venture investors started to place actual value on “big ideas.” The bolder and more idealistic the mission of the company, the more appealing the investment and the larger that investment could be. Founders were incentivized to sell an idea instead of selling an actual product, leading companies to focus on marketing, not product-market fit.?

Founders developed cult-like followings, and quirky behavior was seen as the marker of a successful entrepreneur. Sleeping on a beanbag in their office? Walking down the streets of NYC without any shoes on? They must be genius. The idea of a responsible, experienced operator began to feel boring.?

The “raise and deploy” cycle?

To be successful in such a competitive environment, VCs placed big and bolder investments, betting high on 20 companies with the hope that 1 or 2 of them would deliver unicorn-sized returns. The success of a given investment was based on how much the valuation went up in the next round. And rounds were being raised in rapid succession.?

To make these investments, VCs began raising funds more and more frequently. Until 2016, most VCs raised funds every 22 months. Since 2016, VCs have raised new funds at an average of 10 months (Source: Pitchbook). The size of those funds grew tremendously, with funds under management at the top 20 VCs growing nearly 60% from 2016 to 2022 (Source: Pitchbook).?

(Data source: Pitchbook)

As funds grew, VC’s focus shifted from getting paid on their outcomes to getting paid on the size of their funds . Management fees are fixed, not performance triggered – and very lucrative. In almost every asset class, the management fees decline as assets under management grow. That’s not the case in the private markets, thus creating the temptation to raise more capital and raise more rapidly to guarantee risk-free income for the fund and its partners.

The market reinforced all of this because we were in the middle of the longest bull run in our history. Valuations kept rising from 2009 to early 2020, and investments kept flowing in. 2021 saw almost 600 new unicorns - so many that we had to search for a new term to differentiate the biggest rocket ships of the bunch. As valuations continued to climb, founders, employees, LPs and VCs all saw returns. And even if an investment failed, there was always the promise of the next big thing right around the corner.?

Of course, we all know how this ends. The music stopped, aided by the pandemic and the economic turmoil it caused, leaving us to contend with a much more realistic understanding of what a company is truly worth. With inflated multiples stripped away, valuations have been brought back down to earth . Two-thirds of companies that have gone public since 2020 are worth less than the capital they raised in the venture market.?

And then came SVB. To be clear - what happened with SVB was a unique crisis, based on bad investment decisions and poor management. Still, it’s all connected, and it immediately injected risk into the early stage system at a level we haven’t seen in over a decade.???

It’s also led to a lot of questions about the status quo of venture investing.?

VCs have been the most insulated to the outcomes of the past year due to their fee incomes from funds under management. This is the tension we are contending with today. Founders are doing everything they can to avoid raising money. Employees are starting to prioritize stability over a seat on the next VC-backed rocket ship. And LPs, scarred by VCs raking in management fees while delivering negative returns, are calling into question the entire system .?

Many venture capitalists see this market as an existential threat. I see it as a massive opportunity for us to rethink venture investing.?

It’s time for a new era of VC, one in which the primary way that the VC makes money is delivering compounding value to its investors. We need a more evergreen, sustainable way of investing that incentivizes value creation in the form of compounding versus managing fee income or placing fragile bets. We need to refocus portfolio companies on profitability , place more value on customer experience and prioritize product-market-fit.

The reality is, investing in early-stage startups doesn’t have to be so risky. We just have to be willing to look past what is shiny and focus instead on the fundamentals.?

I’ve heard from many people in my network that there hasn’t been a worse time to be in VC and tech. I completely disagree – there’s never been a better time, because this environment is serving as a forcing function to drive us back towards fundamental value creation. If we focus on building value, compounding returns and re-aligning incentives, the companies that are being created and funded today are the ones that will shape the next decade of innovation in tech.