Is Venture Capital a Bubble?

Saw someone else post about this and recently crossed my mind due to the hot IPO market. It does seem like theres a ton of shitcos being unloaded onto the market via spacs and IPOs.

VCs are playing hot potato with unprofitable companies only to make them grow fast and then sell them to the next guy.

Is it possible this is a bubble or can lead into that territory combined with current insane valuations. How would this end up?

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Comments (31)

Mar 5, 2021 - 9:33pm

People have been calling VC a bubble for over a decade.  If you are bearish on tech, then you may think it's a bubble.  If you are bullish on tech then it's not a bubble.  I personally believe we are only in the first inning of tech and we have so much more to go ie. quantum computing, battery tech, space, block chain, shit idk about etc...

Also

unprofitable ≠ bad company

and profitable ≠ good company 

Mar 6, 2021 - 3:38am

I agree that valuations for some companies don't make sense but overall trend seems to support continued growth in venture.

Howard Marks has published his thoughts on growth. I think you can equate growth pretty well to technology. Increasing moats of dominant companies, with low marginal cost and ability to cross international borders etc.

On the smaller side, cost of starting up a company has come down significantly and venture is gaining traction in key hubs outside of SF.

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Mar 6, 2021 - 3:44am

I think so. I've only been doing angel deals for a few years and the jump in valuations has been noticeable. 

We are playing it by buying in at seed or Series A and flipping ASAP in the next round. This way we don't have much capital at risk + the IRR has been great so far. 

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Mar 7, 2021 - 11:04am

Is this not the strategy that VCs typically do? Flip right after the subsequent round? Seems logical, and something that I'd do.

If you had to put an average time between buying in and flipping, what would it be for you? 1-2 years?

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Mar 7, 2021 - 1:42pm

No. We are usually the only ones ones in a round doing it. Most people hold hoping for acquisition/IPO and double down on their winners (hence pro rata rights). 

  • Analyst 1 in IB - Gen
Mar 9, 2021 - 9:30pm

how do you get into angel investing and where do you find these startups looking for investors to partner with?

  • Analyst 1 in PE - Growth
Mar 11, 2021 - 1:30am

The only requirement to start angel investing is to be an "accredited investor." If you meet the income/net worth requirements and want to invest in super early companies, you can basically pick your own adventure. Most people without significant connections in tech typically start off investing on sites like AngelList or SeedInvest. But you can source investments however you can/want. Personal network, cold outreach, etc

  • Prospect in IB - Gen
Mar 6, 2021 - 4:59pm

Sure VC valuations are up, but that's mostly a function of them being too low in the past. Look at these late stage private companies which are massively increasing their valuations in their final pre-IPO rounds and massive IPO pops. We know low liquidity means there will be pricing discrepancies, so why wouldn't 0 liquidity in private markets do the same? Tech companies have shown their ability to have high growth for far longer than thought possible and have terminal value possibilities in the trillions. Even late-stage names are often highly undervalued as seen by Roblox going from a $7b to $29.5b valuation during their Series H. I personally would invest at a $100b valuation.

There are plenty of shitco SPACs (everything Chamath is selling), but those aren't usually the tech companies with the super high valuations.

  • Business School in PE - LBOs
Mar 6, 2021 - 7:36pm

There's a big distinction between companies that are unprofitable at a company level and companies that are unprofitable at a unit level. For a casual observer, it's pretty easy to lump them together since we're seeing both types of companies go public these days.

There are plenty of sketchy EV and other types of companies with limited traction, high burn rates selling uneducated retail investors on ambitious promises that have a low probability of ever being realized. I think this is classic bubble-type of behavior and these will mostly have very bad endings for everyone involved, similar to a lot of the dot com busts of the 00's. But most legit VC firms aren't behind these companies.

Meanwhile there are plenty of companies going public that, while still unprofitable at the company level, have incredibly strong unit economics and are unprofitable only because they're investing heavily in S&M to acquire customers with high retention rates and ergo CLTVs. If it costs you $10 to acquire a customer that delivers $5 in gross profit per year but has 90%+ retention, then you take that trade all day even though you lose $5 in that first year. Most of these companies are SaaS companies like Snowflake and while you could argue that the current valuations for these businesses are frothy and leave little margin for error for future growth prospects, they're certainly high-quality businesses.

VCs are mostly focused on generating the latter types of businesses and lately they've done a really good job, returning a lot of money to LPs, who in turn are very eager to keep pouring money back into the asset class, which inevitably makes it more competitive. I do expect VC returns to come down as more money enters the space - that's how these things tend to go, but that doesn't make it a bubble.

Mar 6, 2021 - 8:20pm

Not sure venture has done very well? I have an updated data set floating around somewhere but can't seem to find it. It wasn't really that much better just FWIW.

VC is very very heavily weighted towards a handful of firms at the top, if you can secure an allocation with them, it's a no-brainer but I'm not sure how much capacity they really have? From what I've heard, unless you're a long-time LP you're not getting the chance to invest with them.

preqin

  • Business School in PE - LBOs
Mar 6, 2021 - 9:19pm

Here you go. Talk to LPs in the know. VC firms have been returning a ton lately. A lot of the below numbers were still "on paper" when this data was collected, but those returns are being realized very quickly with the recent bevy of IPOs + more on the way.

returns

As for the point about VCs being heavily weighted towards the top, yes that's always been true and still is to a large extent, but I think it's becoming less true. As you point out, the top VCs only have so much capacity (although they are still expanding and raising larger funds), so there have been some newer, less established firms starting to eat pretty well. That probably won't continue indefinitely -> the nature of the beast has always been that once an asset class returns well, more dollars pour in and competition inevitably drive the returns down. But I don't think that's a "bubble" per se. It's an asset class that has outperformed over the last decade being rightsized.

Mar 6, 2021 - 9:51pm

Ty and you are correct about emerging managers. IIRC they avg out to higher returns (fund 1 & 2) > established firms. Can't remember if it was net of fees though.

Mar 7, 2021 - 3:24am

The issue, especially now (and the same can be said about a competitive M&A process or a cutthroat SPAC process), is that the pre-money valuation ascribed to a company in a venture round is largely subject to momentum (ie. a valuation being raised like crazy because everyone is now interested) and as a result, VCs will fight for a deal to make sure they can participate in a round for their own optics. Fundamentals or even basic diligence are often out the window when valuations are agreed upon as a result. If capital continues to flow freely and LPs are comfortable with VCs investing in 90% dog companies with a handful of successes, then honestly this can go on. But it really depends on the size too, for example if you have a Vision Fund sized investment pouring outsized amounts of VC capital in the form of huge bets, then the value "normal" VC funds offer can be diluted. It's a tricky space but to call it a bubble is tough given the actual model in VC hasn't actually changed much 

Mar 7, 2021 - 2:19pm

As somebody with zero exposure to VC (and therefore 0 institutional knowledge of it), I say yes. Feels like we are in an everything bubble. The seemingly infinite amount of money being made available for 'alternative assets', compared to the finite number of investable opportunities (ie, real businesses) has made everything expensive.

It's making things hard for our firm - we can't provide competitive debt costs and our equity is more expensive/tedious than what's available from public markets and our smaller/nimbler/stupider competitors. We either underwrite below our economic thresholds or go without a deal because there's 20 other dudes with cheaper paper lined up for every asset that isn't pure shit. Hell, I'm sure you could even sell a literal pure shit manure farm for double-digit multiple on 2027-EBITDA if you market it as some bio-diesel alternative to fossil fuels and throw in "electrification" or "energy transition" buzzwords and a few frothy TAM growth projection charts your kid whipped up with crayons into your deck.

Mar 7, 2021 - 4:59pm

Tremendous bubble. Equity has been in the largest bubble in history - and technology is mostly a scam. For example, the entire saas field is a complete scam and is only possible because the vast majority of corporate tech procurement are morons/marks. Then there is the legion of companies that sell a dollar for 75 cents like uber and Amazon. It's true it's been going for decades but this time is not different. Also most all software/web companies can just be Craigslist, ie 10 fat guys in a basement instead of 3000 frat bois. So as soon as equity investors get a whiff of discipline tens of thousands of brown nosers will get fired (read the mythical man month).

  • Business School in PE - LBOs
Mar 14, 2021 - 6:10pm

"the entire saas field is a complete scam and is only possible because the vast majority of corporate tech procurement are morons/marks"

Lol ok. Corporate tech buyers aren't morons - they can be "marks" but that's only because corporate bureaucracy creates misaligned incentive structures. You've obviously never worked in a non-finance job - good luck trying to run a company without SaaS products. Do you want your employees to be able to send emails? Or create documents? Well guess what you need SaaS. Your mileage can vary on how much value those products provide but by corporate spend standards, software is actually incredibly cheap. What makes it so valuable is that it's low-price but high-margin.

If your definition of "scam" includes anything where corporate buyers occasionally pay too much, then most of the non-tech industry is also a scam. Besides, more of and more of SaaS is being sold directly to users. Zoom might be overvalued but explain to me how it's a scam?

"Then there is the legion of companies that sell a dollar for 75 cents like uber and Amazon"

OK buddy - you used to be able to argue this with a straight face but it's not 2005 anymore. Amazon churned out $24B in free cash flow in 2020. You don't do that with negative margins.

Mar 7, 2021 - 5:23pm

I think this post is incorrectly assigning "venture capital" to mean "tech". How can venture capital be a bubble? Venture capital is equity funding to early stage start ups. That doesn't have to mean tech. Now the fact that so much of it is tech these days, that's another story. And really the question is whether these tech start ups with massive valuations are a bubble. I think they are. Some of them are great, sure. But a lot of them I think don't have nearly the return potential to justify the wild valuations they are receiving currently. They are simply hopping from funding round to funding round to stay afloat. Not unlike the fundamentals of a ponzi scheme. Except nothing illegal because the investors know what they are funding, and do it anyways. But does that make VC a bubble in that scenario? In fact, could be just the opposite. Smart VC cashes out after that first big valuation or IPO, so the VC actually benefits the most on these unsupported and unsustainable monster valuations.

Mar 8, 2021 - 3:49am

This is a fair point. I meant tech, disruptive tech, usually associated with VCs unloading them onto the market

path less traveled

  • Prospect in IB - Gen
Mar 7, 2021 - 7:19pm

Venture capital is NOT a "bubble" ... Nothing is going to "pop" or collapse or anything. But, there are some major trends in this ecosystem going forward.

A lot of these skyrocketing valuations stem from really simply the ease of access to capital. Let's think back to ECON 101 and supply vs. demand. A large demand but limited supply leads to higher prices, it's like trying to get an Xbox during Black Friday. Well, we can say the same about venture as an industry. 

The sheer number of firms and opportunity to raise larger rounds has skyrocketed this past decade, seems like every guy and his dog wants to go and start a fund. Funds are getting larger and larger as companies demand higher valuations... there are investors that will pay upwards of 20x Revenue just to get a bite of the hottest startups. But, keyword is "hottest"... yes, the bar to to build a startup as gone WAY down since the 1990s. You can pretty much get a company running over the weekend, with Ecommerce through Shopify, Salesforce CRM, and throwing everything up into the cloud running AWS/Azure. There are TONS of startups which is great, but it doesn't mean that every startup will become a unicorn.

YC was a major catalyst accepting only the best of the best startups and giving them the attention and resources to really succeed (that's how we saw companies like AirBnB '09, DoorDash '13, Stripe '09..etc). But, YC batches have gone larger, even virtual now and yeah, many are still raising capital from VCs but by no means does YC guarantee anything. What really leads to successful outcomes is the support of the TOP quartile of VCs (ex: Benchmark, Greylock, a16z, Sequoia, Bessemer, NEA). Raising your Series A from these funds is like graduating from HYP (like doesn't guarantee success, but it makes life a hell of a lot easier). These VC firms not only have strong reputations ("clout"), but add a ton of value to startups with anything from Sales, Strategy, Recruiting ... etc.

But, one major problem is that there are not that many *Great* startups out there... tons of meh ones. But, the best startups with world-class teams and disruptive visions are the ones that command high valuations and can lead to bidding-wars like Clubhouse. The top funds are the ones with the best support and names are the ones that will get into these hot companies... As deals become more competitive, these firms are launching Seed Strategies (Sequoia Scout Fund, LSVP Scouts) and Venture Studios to discover or incubate these companies from the beginning.

There is a saying now that "Seed is the New Series A"... companies are commanding higher and higher valuations earlier in the cycle (some even pre-revenue/product). They will continue to grow and eventually some MF like SoftBank will come in and lead a $250M+ growth round, which has evidently led to these venture funds raising Growth Funds (BVP, Menlo, Sequoia, Index...) so that these traditional early-stage venture funds can maintain their pro rata despite more capital dumping into these companies. 

As for going back to the original question with these valuations, what's really going to happen is that these companies are going to be reflected on fundamentals in public-markets and valuations will be corrected over-time. Yes, this has been a really "hot period" for SaaS but imo vcs really just care about developing potential fund-returners, exiting the company after 5-7 years via an IPO/SPAC or Strategic Acquisition, and then adding the logo to slide deck for LPs, so they go and raise the next fund.  

TLDR: Not a bubble, Top VCs have the best names/resources so they get the best startups (sometimes one will slip through the cracks)... leading to high valuations. Once they realize their gains, most could care less about the company. 

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