The tech slump is encouraging venture capital to rediscover old ways
Summary
- Small, profitable firms in strategic industries are now all the rage
Until last year, venture capital (VC) had been riding high. With interest rates close to zero and little yield to be found elsewhere, large companies, hedge funds and sovereign-wealth investors began ploughing cash into startups, sending valuations upwards. In 2021 alone the amount of money flowing to startups doubled to nearly $640bn. Then soaring inflation and surging interest rates brought the market crashing down. Last year the investments made in startups worldwide sank by a third. Between the final quarter of 2021 and the same period in 2022, the valuations of private startups tumbled by 56%.
The downturn inevitably draws comparisons to the dotcom crash of 2000-01, when deep winter set in and VC investments froze. Luckily for both founders and their backers, conditions are not so frosty today. Startups’ balance-sheets are stronger than they were 20 years ago; valuations are not quite so detached from revenues. In America alone, venture capitalists have about $300bn in dry powder. Nonetheless, the industry that is emerging from the tech slump and into an era of dearer money looks different from the one that went into it. In many respects, VC is returning to the ways of decades past.
One change is a focus on small, profitable firms. This is a habit venture investing sometimes forgot in the boom years, when rapid growth and the hope of big profits tomorrow were prized over profits today. Many backers who were in search of a quick return piled into older, “late-stage" startups, which would probably go public soon and seemed assured of heady valuations.
Today, however, stockmarkets are volatile, making it hard for venture investors to gauge the value of late-stage startups. As interest rates have risen, lossmakers have fallen out of favour: according to an index compiled by Goldman Sachs, the stock prices of unprofitable tech companies have fallen by two-thirds since November 2021. VCs, too, are telling their portfolio firms to tighten their belts and generate cash. Increasingly their new bets are on younger firms, and those which are cutting costs sharply and likely to turn a profit sooner.
A second shift is a renewed emphasis on strategic firms. In an echo of VC’s earliest days, when investors often backed semiconductor-makers that vied to win huge public contracts, many today are eyeing up firms in areas that stand to gain from governments’ new fondness for industrial policy. Administrations in both America and Europe, for instance, plan to spend hundreds of billions of dollars supporting chip firms and clean tech.
Venture capitalists, understandably, know how to spot an opportunity. Andreessen Horowitz, a stalwart of Silicon Valley investing, has launched an “American Dynamism" fund that partly invests in firms which tap support from Uncle Sam. Other venture investors, including Temasek, a Singaporean sovereign-wealth fund, say they increasingly expect their investments to align with states’ strategic aims.
A final shift in VC’s approach is an emphasis on better governance. In the boom years too much venture money chased too few good investments. The mismatch gave founders the upper hand in negotiations, helping them keep oversight relatively light. After the spectacular blow up last year of FTX, a venture-backed crypto exchange, it became clear that none of FTX’s big venture- and sovereign-fund investors had taken seats on the startup’s board, leaving Sam Bankman-Fried, the founder, and his colleagues entirely to their own devices.
Now venture finance is harder to come by. Tiger Global and other funds that were previously hands-off have started to retreat. Other investors say they intend to take up their board seats. That reduces the power of founders to dictate terms and should improve governance. A lack of venture dollars may also encourage startups to go public sooner, as might trustbusters’ greater scrutiny of big tech acquisitions. The knowledge that they might soon face scrutiny in the public markets could also discipline founders.
Planting the seed
This new sobriety will not last for ever. Venture capitalists are, by nature, excitable: look at the buzz over generative artificial intelligence. Some hedge funds have left venture investing after previous downturns only to return when valuations adjusted. In time the cycle will surely turn once more, sending VC investments to dizzying heights. For the moment, though, the old ways are back—and that marks a welcome change.
© 2023, The Economist Newspaper Limited. All rights reserved. From The Economist, published under licence. The original content can be found on www.economist.com
