When will VCs hit the brakes?

I find your lack of faith disturbing

I do not want this morning column to become Old Man Shouts at Stocks; that’s not its goal. To prevent that from happening, we’re flipping the script today.

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Instead of talking about what the public markets are doing and how their moves may impact startup valuations, we’re going to ask when VCs will hit the brakes.

When will the venture crew slow down?

It has long been the consensus view that cheap money thanks to low global interest rates helped pump more money than ever before into the startup market. This resulted in the assembly of larger, more rapid venture capital funds, and larger, more rapid startup funding events.

The result of both was that startups got expensive as hell to buy into during their growth curve.

Not everyone is thrilled. Venture capitalists are hardly celebrating paying 75x, 150x, or even greater multiples for shares in nascent startups. But the game was set by rules external to the players, meaning that the venture crew has merely responded to in-market incentives in recent years.

The question before us — and it’s perhaps the most important question in startup land for the next few years — is what happens next. The incentives that venture capitalists followed for the last decade or so are finally changing, with the price of money expected to rise sharply this year (due to tightening monetary policy generally). This has led to the anticipated result — falling valuations for riskier stocks like richly valued technology shares.

What this means in practice is that there is an inverse relationship between the price of money (where interest rates are set by key central banks, like the U.S. Federal Reserve) and the value of startup exit prices.

This is simple to understand: Startups are priced first on hope (seed-stage), then momentum (Series A through C), and later by exit comps (late-stage). The startup exits that truly matter to venture funds tend to be post-late-stage, so we care most about how upstart tech companies are valued by their public market analogs. This means that more expensive money makes bonds and other, comparatively safer investments more valuable as startups lose in-market pricing power. So, up goes the price of money, down goes the exit value of startups.

This should impact earlier-stage startup prices in time, but we’ve tread that ground before.

All that in hand, when will venture capitalists tap the brakes? From where I sit today, the answer is clearly not yet. This is for two reasons:

  • Sheer institutional momentum thanks to already-raised funds, as well as the desire to back hot companies that could enjoy quick markups to keep LPs (the money behind venture capital) content.
  • The belief that, in the long run, the companies being built today will have enormous value, perhaps besting whatever turbulence induced by near-term valuation chop.

Some of that is sticky, like momentum. After all, venture capitalists have already closed huge new funds that they are being paid to deploy. But the latter point is more variable. That means we’re looking more for a sentiment shift to change startup investing activity — and therefore, prices — than we are are some other factor, like smaller venture capital pools.

This lets us take a guess at when things will actually change in the venture capital market: When VC unease about high startup prices viz a viz possible exit prices allows investor concern to outstrip investor FOMO.

If startup failure rates are going down, and long-term values for new tech companies are going to be huge, it’s fine to be near-term greedy because the long-term market will pay you regardless of the day’s stock market moves. This allows FOMO to push nearly every investor to talk themselves into whatever deal is in front of them that looks tasty.

What precisely will shake that confidence isn’t clear, but we can take a few guesses: continued deterioration of public comps for startup exits, more pulled or delayed IPOs, and perhaps rising hesitation among crossover investors in startups’ final funding rounds.

Where we sit today, that’s not happening. Yet, at least. The New York Times has a fun piece out today asking startup investors about what the flying hell is going on in the venture capital game. A small taste:

“The pot of gold at the end of the rainbow has become bigger than ever,” said Mike Ghaffary, an investor at Canvas Ventures. “You can invest in a company that could one day be a trillion-dollar company.”

With that attitude, it’s hard to talk a VC out of paying an insane multiple for a startup today — it could be the next Microsoft down the road.

It’s also very easy to wonder how many tech companies are going to be worth a trillion dollars (effectively zero when compared to the number of startups in the market), and how many startups are being valued like they will be someday (the entire late-stage market today, I think?). This argument is possible to condense into GIF form:

Optimism over caution. Until the latter bests the former, it’s FOMO season for startup investing. After all, it’s easier to agree with incentives when they make you look brilliant. It’s harder to admit that the landscape is rapidly shifting when you’re currently king of the hill.