By Eugene Timko, Investment Director of Finstar, for Forbes.ru
The bursting of the dotcom bubble toward the turn of the millennium devastated technology companies and the broader startup market. Investors had enthusiastically committed vast sums to unproven models predicated on the belief that the internet would soon conquer the world. However, it was ultimately the demand side, rather than the ideas behind the models themselves, that let investors down. In the early 2000s, the level and rate of internet development meant that there were simply not enough consumers for many of the new models online businesses had developed. Technical restrictions were crucial to this demand side issue. Smart phones, for instance, were still science fiction, and the permanent internet access that came with them was thus nonexistent.
It is therefore probably fair to say that many of the models were functional enough: it was simply that the rates of development investors had expected were unrealistic, given the realities of the time. Webvan, the foodstuffs delivery service, and Kozmo, the rapid local delivery provider, are fine examples of this. They were the two most important startups of the dotcom era, raising USD 400mn and USD 250mn, respectively, from venture investors. It is telling that both models are these days de rigueur in the VC world. Indeed, Kozmo might be regarded the antecedent of the on-demand segment in which Uber, Postmates, et al work. Meanwhile, there is scarcely a large, modern retailer – from Whole Foods to Amazon – that does not deliver foodstuffs. But in 2000, after a sharp decline of the NASDAQ (the average P/E of a company traded on the index at the peak of the doctom bubble was 200x, compared with 20x today), investors rethought the prospects for internet development and withdrew support for the overvalued, unprofitable companies. As we know, this ended badly, with the majority of the big name startups of the time going bankrupt, and many investors leaving the venture market for good.
The events of recent years in the startup market have been compared with those days. As was the case 20 years ago, one of the major reasons for the inflation of the bubble on the tech market is a surplus of money. Venture capital is a tiny segment of the wider capital markets. The assets of the VC segment do not exceed 1% of overall financial assets (the entire annual volume of the worldwide VC is USD 100bn, compared with the tens of trillions of assets held overall). When, responding to the 2008 crisis, regulators turned on the liquidity spigot, even a small pass-through to the VC segment brought about rapid growth.
The last few years have been especially explosive: from 2013 to 2015, the volume of investment almost doubled, reaching its highest level since the end of the dotcom bubble. Terms like mega-transaction (those over USD 500mn) and mega-fund (those with more than USD 1bn under management) were used enough to enter the financial vernacular. Five years ago, it seemed absurd to imagine a company raising over USD 1bn in a single round, but these days, it’s almost commonplace: Uber might close several such transactions a year, while the Chinese company Ant Financial attracts as much as USD 4.5bn a time.
But, as the lesson of the beginning of the 2000s reminds us, markets cannot grow like this forever: at some point, investors start seeking a decent rate of return on their capital. Given there are usually two years between funding rounds, it was unsurprising to see the first signs of a venture capital hangover emerging at the end of 2015. Indeed, 2016 was the first year in the modern history of the venture capital sector when the market contracted, causing problems for even some of the more well-known venture-backed startups. According to CB Insights and KPMG, venture capital volumes returned to 2014 levels of some USD 25bn per quarter (from the record breaking 3Q15 number of almost USD 40bn). The declining VC investment trend of 2016 affected more established venture segments, such as consumer internet and SaaS sectors, while the largest VC segment of the recent years, fintech, has also experienced a reduction of investment levels. However, the overall drop in volume was mainly driven by megadeals (rounds of over USD 100mn); total funding to fintech companies is likely to exceeded 2015 totals. The Chairman of international fintech-focused investor Finstar, Oleg Boyko, believes that there is a good explanation for this phenomenon. “Fintech is so transformative to the global financial services industry, and there are so many potential areas where innovations could be applied, that it will remain a high priority for the investment community for some time.” Mr Boyko also stressed that the effect of Brexit and the election cycle in the US were reasons for the soft venture capital markets in the EU and the States. “In Europe, there was no single VC fintech deal of USD 50mm or more in 2016,” he added.
Despite the decreased activity, total global venture investment volume in 2016 is likely to exceeded USD 100bn – a high enough level for startups to continue financing their operations. Possibly we are in a bubble; however, if this is the case, it is a bubble whose growth peak has already passed. Furthermore, 2016 at least provided a lesson to investors that might ultimately increase the efficiency of venture investments – or at least for a little while. Usually investors have bad memories, but it would be nice to believe that the lessons provided in the past year will be salutary.
Those at the sharp end of the venture capital business, often say that good companies do not always make good investments. Participation in a successful startup’s capital raising rounds – even those of the most successful startups – does not in itself guarantee an acceptable rate of return. It seems that many investors in 2016 realized that for the last several years they had invested in good companies at prices that were too high. This resulted widespread startup overvaluations in 2016, and startups across the world were marked down. For example, based on the results of its round of fundraising at the beginning of 2016, Jawbone, the American manufacturer of fitness trackers and acoustics, had lost half its value (some USD1.5bn); by the end of the year, it was facing difficulties paying for the deliveries of new devices, and its very future now appears to be in question. Similarly, experts had once valued Xiaomi, a Chinese smart phone manufacturer, as the most expensive startup in the world; however, unable to withstand pressure from Chinese competitors, it has now lost 90% of that USD 46bn price tag. Meantime, Global Fashion Group, owned by Rocket Internet, the German startup incubator, and represented in Russia by Lamoda, saw its value reduced from USD 3.4bn to USD 1.1bn.
Actually, this situation is indeed reminiscent of what happened after the dotcom boom. Having lost a significant part of their valuations, many startups have failed to attract new rounds of investment – and therefore have been unable to continue their development and, in some cases, business operations. However, we should not now expect a repetition of the dotcom bust: that time, the economics of many companies could not function in principle, as the demand simply did not exist; whereas now, such models as Dogvacay (‘the Uber for pet sitting’) attract USD 50mn and can become decent businesses that have revenue and turn a profit.
Nevertheless, as with 20 years ago, damning the torpedoes in the rush toward business growth at any cost can be injurious for a startup with an unproven business model. Raising money at a high valuation has left many companies struggling to attract investors at later rounds, or in some cases, has slammed the door on the possibility of raising additional financing altogether. Sometimes, it is better to raise a smaller round at a lower valuation. This sounds counterintuitive, but it was a point used to great effect in the television serial Silicon Valley, and it reflects the reality of the venture capital world. The logic is simple: scaling for a big number of startups demands a significant number of investment rounds (for example, before IPO, companies usually attract at least four rounds of investment). Having raised capital at a rich valuation in one of the first rounds, the company will either have to show huge growth before the next round of investments are attracted, or to agree to a reduction of its price – a process fraught with reputation risk and which can frighten away new investors. In 2016, many startups had to solve just such a dilemma.
Another important event also took place in 2016: America elected Donald Trump to take over from one of the most progressive presidents in the world in terms of tech policy. Indeed, President Obama, during an interview with Bloomberg, even hinted at possible career in the venture capital industry after he leaves office. There have been politicians involved in venture capital (US Vice President Al Gore worked for KPCB, one of the most famous venture capital funds), but President Obama would become the first former president to enter the field. This would be a fair representation of his attitude to the industry. Indeed, in his last year in office, President Obama introduced special visas for those who want to develop their startups in the America, allocated USD 4bn for the promotion of coding and programming courses in US schools, and wrote articles about self-driving cars, flights to Mars and a general technological progress. However, 2017 will see the start of a new administration, led by a man who has already surprised many people with his nonstandard views and his selections for his cabinet and team of advisers. It is true that Peter Thiel, perhaps the world’s most famous investment angel, who managed to grab 10% of Facebook for USD 500,000, Elon Musk, the founder of Tesla, SpaceX and Solar City, and Travis Kalanick, the head of Uber, will appear on one Trump advisory team; however, on the whole, the technology community has raised serious questions about appointment of Trump. This is not a shock, given his ambiguous attitude to new technology and innovative businesses (frequently, he simply does not understand them, as was the case in his suggestion that iPhones be prohibited after Apple refused to cooperate with the FBI).
The venture capital industry is not the quietest market as it is. But next year is likely to see more uncertainty, new trends, and more fat tails of possible outcomes. What unlikely is a repeat of the dotcom crash of the turn of the millennium.