On Monday, July 10, Snap, Inc’s share price dropped below its IPO price for the first time.  The trend continued Tuesday as Snap shares ended trading at $15.47, off $1.53 from its IPO price of $17.00 in March.  Like Snap, on Tuesday Blue Apron closed at $7.14 or 29% off its original share price.  Blue Apron went public last month at $10.00 per share.  In her Wall Street Journal article, Corrie Driebusch states that of the firms to have IPO’d in 2017, 46% have closed below their IPO price at some point.  Even more concerning for investors is that Cloudera, a data and advanced analytics company preparing for an IPO, had its latest valuation come in lower than its last private funding round.

Source: Yahoo! Finance

Source: Yahoo! Finance

Shaky Performance for Some Venture-Backed IPOs

Starting in late 2016 and through two quarters of 2017, the Venture Capital community applauded the return of IPOs to the marketplace.  Venture LPs had patiently waited for the market to gain momentum as investors saw only 40 IPOs in 2016, down from a total of 77 and 125 in 2015 and 2014, respectively.  Through the first two quarters of 2017, 27 venture-backed companies have gone public, with five receiving unicorn valuations (valuation greater than $1 billion).  This year’s pace has given hope to VC investors looking to realize their VC portfolio value, which in recent times has become more difficult to achieve as companies have been inclined to stay private longer.

Unfortunately for LPs holding portfolios with venture-backed companies, the poor stock results of firms like Snap and Blue Apron might be proving that the market correction experienced by venture capital-backed companies in 2015 was not severe enough.  As newly public firms open their books, it seems Wall Street analysts are valuing firms differently than fund managers had in their later-stage rounds.

Questioning Valuations

PitchBook reports that over the last fourteen quarters, venture capital investors have allocated $154.7 billion to 6,244 late-stage deals.  The average funding round over that time reached $24.8 million.  The previous fourteen quarters, from Q3 2010 to Q4 2013, saw $86.6 billion invested in 6,063 deals or an average of $14.3 billion per round.  So, as Alan Greenspan might say, are the valuations of the last several years a bout of “irrational exuberance” by investors?  Or are these unicorn venture-backed companies fundamentally stable and positioned for exponential growth?

The Wall Street Journal and Dow Jones VentureSource have tracked Venture Capital companies with values of greater than $1 billion since 2014.  The Dow Jones tracker indicates there were 45 unicorns in January 2014, and that number has grown to 163 today.  In May of this year, the number peaked at 165.  The leader of the unicorns is Uber with a valuation of $68 billion.  Has this growth of 117 unicorns over the last two and half years been driven by innovative technologies disrupting industry, or fund managers needing to place large sums of investor money?

Source: WSJ & Dow Jones VentureSource

Source: WSJ & Dow Jones VentureSource

Money to Spend

Since 2008, investors have allocated $261 billion to venture capital funds, per PitchBook.  In April, Goldman Sachs estimated that there was over $121 billion of dry powder in the VC market.  Additionally, larger funds are becoming common to venture capital.  PitchBook reports the number of billion-dollar-plus funds continues to rise, with eight closing since 2016.  As an example, New Enterprise Associates closed a $3.3 billion fund in June of this year.  The most recent IPO stock results make a case that the large amount of dry powder, in conjunction with the pressure to invest larger sums of capital, may have driven fund managers to make irrational valuations.

For the pessimist, the market performance of recently IPO’d companies certainly calls into question the true value of these 163 unicorns.  Similarly, LPs are questioning whether their paper returns will be realized or if the long wait for a big exit will be a reality.  Only time will tell, but these facts do require LPs to assess how they are investing in venture capital.

The public markets seem to be proving that VC valuations are too high, but is the solution to stop investing in Venture Capital?  The answer is “no,” as Venture Capital has created substantially higher returns than most other investment sectors and most likely will continue to do so.  However, investors should look at how they are choosing fund managers.  For investors wanting to earn the higher returns available through Venture Capital investing, it is worthwhile to spend the necessary time to diligence and identify pedigreed fund managers, who are operating smaller funds and have the unique ability to drive alpha at the deal level.