Amid the Silicon Valley Bank-led chaos of the last few days, Y Combinator made an intriguing announcement: It’s pivoting away from late-stage investing. It won’t be the last venture group to pull back from an expansion of its traditional investing remit.
During the COVID-19 pandemic’s first years, the pace at which venture capital firms could raise money expanded. PitchBook data indicates that U.S. venture capitalists saw their capital inflows more than double from $23.5 billion in 2012 to $51.4 billion in 2016. But the investing cohort was just getting started: It further bolstered its fundraising from $60.5 billion in 2018 to $154.1 billion in 2021 and $162.6 billion in 2022.
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This dramatic rise in capital available to venture investors had a number of interesting impacts on the startup market. First, startups were able to raise more, more quickly, more frequently. Some startups raised two or even three times in a year. This led to dramatic markups and paper valuations that today no longer align with reality.
Another result of the boom in venture fundraising was the ability of firms to expand their investing footprint. One trend that lasted for years during the final stage of the last startup boom was late-stage investors going early-stage. The logic here was that if large venture funds could invest a round or two earlier, they could get far greater ownership of great companies at a lower average per-share cost. This, in time, would lead to simply nasty returns.
To pick some examples of this effort, recall that Andreessen Horowitz, a firm that has raised 12 funds with more than $1 billion in them during its life, per Crunchbase data, announced a seed effort in 2021 and a pre-seed endeavor in 2022.
The trend was sufficiently pronounced that this column took it on in 2021, collecting notes from a number of VCs on the changes to their investment landscape (emphasis added):
“Overall, once there are real metrics and proof of sustainable growth (even if it’s just a few months or spikes), funds start trying to preempt,” Maria Salamanca, an investor at Unshackled Ventures, told us. She didn’t name names, but pointed out that “Series B funds and beyond know that missing out on the earlier rounds of early growth likely means overpaying massively after the B or not even having a chance.”
[Rudina Seseri of Glasswing Ventures] also alluded to what’s driving this FOMO: “This dynamic is exacerbated by large, multiasset players that have come down market and are offering a different product than typical VCs — very fast term sheets, no active involvement post-investment, large investments amounts and high valuations.”
[Menlo Ventures’ Matt Murphy] was more direct in naming the elephant in the room: “The late-stage firms definitely get super aggressive on As in the [$1 million to $2 million] range. We were just involved with one where a few VC firms were clustered around the same valuation and Tiger came in 50% above that. This pattern is being repeated weekly,” he said.
As you can imagine, other investors aren’t extremely happy about the dynamic — and it is having unexpected effects, [M25 partner Mike Asem] told The Exchange. “I’ve spoken to Series A investors who are frustrated by Tiger (or similar) stealing what normally would be a [Series] A deal from out from under them for a [third] time,” he said, “so when they do have one that no [Series] B shop is competing for … maybe they get cold feet until the traction makes it undeniably good.”
There was so much money flying around that some investors used capital and headcount as a way to either go earlier, as in the above examples, or later, as in the case with Y Combinator.
In human terms, it’s hard to blame the VCs. They had access to a massive amount of inexpensive capital, they had a booming market to invest in and they were offering a largely undifferentiated product (capital). So they went broad, working to either get into startups earlier to lock in pricing (if they were late-stage by nature) or stay around longer in their winning investments (if they were early-stage by nature).
The issue is that a dollar doesn’t spend the same in both venture realms; the methods needed to be a winning earlier-stage investor are different than those that lead to success in later-stage investing. Don’t take my word for it — ask a venture investor what they think of VCs from other stages piling into their niche. They will walk you through it.
The Y Combinator news regarding its pivot back to its core market hit me right in the forehead as I got off the phone with Maëlle Gavet, the CEO of Techstars. She had just told me this during our call (emphasis added):
We think that there’s going to be more and more conservative VC. It was already visible a few months ago, they started getting away from pre-seed. There was this whole phase where VCs were trying to be multistage. And so they started in Series A [and] B, and then [they started investing] earlier and earlier and earlier. And we were seeing them coming in [and asking if they] realize that pre-seed is a completely different universe compared to what you’re doing in Series A and Series B. You have to have a completely different support network. Do you have a chance for your investment to be more than throwing spaghetti at the wall? So what’s interesting now is VCs have gotten more and more conservative. And I think the Silicon Valley Bank explosion is probably gonna make that even more [evident].
So what’s changed to get us from the boom days to today? Interest rates increased, changing the value of assets, especially compared to one another. Tech valuations tanked, startup fundraising slowed, and now, in the face of a less welcoming market, venture investors are retreating to where they have historically found the most joy. Perhaps most of the move to multistage venture was simply predicated on interest rates being zero for so long.
It got somewhat silly. Here’s a riff from Lerer Hippeau Acquisition Corp.’s S-1 filing, a SPAC debut from a venture fund:
As our seed portfolio matured over the last decade, we added a growth strategy to our platform through our select funds. This capital enables us to continue providing financial support to our top performing early-stage companies as they scale, and to selectively make new investments in later-stage companies in the Lerer Hippeau network. With our portfolio now maturing to the stage at which many are considering the public markets, we view SPACs as a natural next step in the evolution of our platform.
From seed to SPAC! That’s the venture soup to nuts. (The Lerer Hippeau SPAC wound up doing nothing and shuttering.) That’s the power of ZIRP.
Is any of this bad for startups? Only in that there’s less money around, which is a generic bummer. But perhaps VCs doing what they do best instead of trying to do everything will lead to better, smarter investing. Maybe private-market investors will listen to the advice that VCs have long given startups: focus matters.