VCS and the Musical Chairs Game - Investment Strategy

A Flourishing Yet Uneasy Landscape for Venture Capital

Currently, the environment for venture capitalists is exceptionally favorable. A significant portion of professionals within the industry are experiencing substantial financial gains, stemming from both realized investments and the increased capital flow into the sector – often resulting in higher management fees, and frequently, both outcomes simultaneously.

Growing Concerns Among Early-Stage Investors

Despite this prosperity, a rising number of early-stage investors are expressing caution regarding the speed of investment activity. The challenges of conducting due diligence and securing investments at reasonable terms are increasing. Furthermore, many founders are receiving subsequent funding rounds before fully utilizing their previous capital.

The Surge in Mega-Rounds

From 2016 to 2019, approximately 35 deals each month involved funding rounds of $100 million or more, as reported by CB Insights. This year, however, that figure has surged to nearly 130 such “mega-rounds” monthly. This trend isn’t limited to established companies; the median Series A valuation in the U.S. reached $42 million in the second quarter, influenced by investors like Tiger Global, which completed 1.26 deals per business day during that period.

Navigating a Bewildering Market

These conditions create a complex environment, even for seasoned investors like Jeff Clavier, founder of Uncork Capital. Clavier, like many of his colleagues, is benefiting from the robust market. One example is LaunchDarkly, a portfolio company assisting software developers in preventing errors. The company recently secured $200 million in Series D funding, achieving a $3 billion valuation – a threefold increase from its valuation early last year.

“This is a fantastic company, and I am genuinely pleased for their success,” Clavier states.

However, he emphasizes, “It’s crucial to deploy this capital strategically and with careful consideration.”

The Risks of Rapid Funding

This proves difficult in a market where founders are overwhelmed with offers and often receive term sheets after initial meetings. TX Zhou, co-founder of Fika Ventures, notes that some funds are making investment decisions after only 30-minute conversations with founders. Fika Ventures itself has tripled its assets under management.

While increased funding provides companies with a longer operational runway, it can also create distractions and mask underlying business issues until it’s too late to rectify them.

Valuation Dynamics and Competitive Pressures

Larger funding rounds frequently correlate with higher valuations, which present both advantages and disadvantages. Elevated valuations can enhance a company’s visibility, attract talent, and garner media attention. However, Renata Quintini of Renegade Partners points out, “The higher the valuation, the greater the expectation on subsequent funding rounds, as you must surpass that benchmark.”

Quintini observes that some founders are intentionally avoiding further fundraising, recognizing their businesses cannot effectively absorb additional capital. Others, however, feel compelled to secure funding to maintain competitiveness, especially if rivals are raising larger sums and aggressively expanding their market presence.

Justifying High Valuations

Many venture capitalists argue that current valuations are justified by companies’ ability to create new markets, achieve faster growth, and expand globally. This holds true in some instances, as evidenced by the soaring valuations of companies like Airbnb and Doordash after their public offerings.

Nevertheless, for a considerable number of companies, “valuation is entirely disconnected from fundamental financial metrics,” Clavier admits, a sentiment echoed by other investors in private discussions.

The Sustainability of the Current Market

While seemingly a positive predicament, the longevity of this market boom remains a key concern. The current situation may not persist indefinitely.

Clavier shares an example of a portfolio company that secured successful Series A and Series B funding rounds but is now facing a Series C preemption with a valuation that doesn’t align with its current performance.

“I am optimistic that they will ultimately meet these expectations,” he says, “but they will need to demonstrate substantial growth to justify the valuation.”

Further Insights

To hear more from our discussion with Clavier, please listen here.