The tech startup space has been red hot in Canada and the United States of late, but is it getting too hot? Several key players in the startup world think so – and predict there could soon be a shakeout.
"We feel there's going to be a pullback in the next six months," says Jim Orlando, managing director of OMERS Ventures, the pension fund-backed Canadian venture capital firm that has financed some of Canada's best-known startups, including Shopify and Hootsuite Media. "People will start to realize we're in a very hot period and it's unsustainable." Adds Steve Schlafman, a principal with New York VC firm RRE Ventures: "Among [investors] and general partners at venture funds, people are starting to proceed with caution."
There are several factors at play. Institutional and high net worth investors have been piling into venture funds, and those funds in turn have been piling into startups. In the United States, for example, venture capital (VC) investment reached $17.5-billion (U.S.) in the second quarter, the highest level since the fourth quarter of 2000, according to the MoneyTree report by PricewaterhouseCoopers and the U.S. National Venture Capital Association.
The money inflow is pumping up valuations. According to OMERS, the number and value of deals have risen by more than 20 per cent in the first half of this year in Canada, compared with levels a year earlier. Median valuations for companies that have received "Series A" financing – the first serious outside financing round by VCs – in North America this year have nearly doubled to $15-million from $8-million three years earlier. It's a similar story for follow-on Series B and C rounds; companies receiving "Series D" financing have seen median valuations soar to $184-million from $88-million in 2012.
"People say they're concerned [about rising valuations] yet they continue to put money into" startups, said Danielle Morrill, chief executive officer of Mattermark, a U.S. firm that tracks deal data in private markets.
Meanwhile, the abundance of private investors and investment dollars has meant venture-backed companies can remain private for longer. Only 59 venture-backed companies went public in the United States in the first nine months of 2015, raising just under $7-billion, down from 90 and $11.1-billion, respectively, during the same period in 2014, according to Thomson Reuters. Meanwhile, the number of private companies with an implied valuation of $1-billion or more – which are nicknamed "unicorns" in the venture world – soared to more than 100, according to The Wall Street Journal, led by such heavyweights as Uber.
But that creates pressure to perform. Several companies valued at unicorn levels in private markets have turned into "undercorns," when their valuations plummeted once they went public, including Lending Club, Etsy and Rocket Fuel in the past year. Some observers say the public markets have brought a dose of reality and rigour to company valuations that seemed to have been marked up in private markets, leading some observers to call the market a bubble – even a "mega bubble."
There are concerns there is so much money sloshing around that some companies are chasing venture money that shouldn't, particularly given that the U.S. economy, now six-plus years into an expansion, appears due for a pullback, Mr. Schlafman says.
But the issue isn't just about frothy valuations. According to Semil Shah, a venture partner with Silicon Valley VC firm GGV Capital, some limited partners – the pension funds and other institutions that feed dollars into the venture capital ecosystem – are getting impatient with all of those startups that are remaining private. The system relies on "exits," or transactions that put cash back into their pockets, and the lack of liquidity is becoming a problem, he said in an interview and a recent blog post.
While "there is a lot of money pumping in, there is not a lot pumping out" of the venture ecosystem, Mr. Shah told The Globe and Mail. "If you are a general partner of a fund and go to your limited partners to raise a fourth fund, but the fourth fund has not [paid back cash returns], people kind of say, 'If you visit me three times with your hat in your hand, on your fourth visit you should be bringing gifts.'"
That isn't happening enough, and the limited partners are complaining about it, he says. If there aren't more exits, less money will flow into the system, and startup companies in mid-stride that still need fresh investor funds may be out of luck and perish, Mr. Shah warns.
There's no doubt we're still in the early days of a huge transformation of the economy led by startup companies that are harnessing the power of software and the internet. But in the short to medium term, venture capital investors are warning their investee companies to be prudent.
"My advice to them is we can't spend like the next dollar is guaranteed, we have to focus on our business model and really hitting key milestones," Mr. Schlafman says. "We can't spend like the good times are going to continue. We have to be super disciplined, we can't be hiring people that we can't afford, we can't be moving into offices that are lavish. We need to run the business like it's a modest enterprise."