Has venture capital become too safe?

Isreali tech company Aquant  credit: Shlomi Yosef

Booming valuations, big financial institutions moving in, and fewer new companies, perhaps spell the end of the traditional VC role.

2021 saw a 2.4-fold rise in venture capital invested in privately-held Israeli technology firms. The number of active unicorns shot up three-fold, and the median valuation of companies raising finance doubled from $20 million in 2020 to $40 million last year.

At one go, perhaps thanks to the coronavirus pandemic, investment in technology turned into a standard financial transaction, and not territory for enthusiasts or specialist venture capital funds. When Israeli pension funds and global hedge funds invest in early-stage software companies, it's a sign that technology has long since gone mainstream. But does that mean that the risk element has disappeared from investment in the sector?

" With the exception of 1999-2001, venture investors generally have priced risk into their deals.," wrote Alan Feld, founder of Vintage Investment Partners, one of the largest and oldest venture capital firms in Israel. Today, Feld finds, there is no risk premium in investment in privately-held technology companies, and risk is no longer a factor in calculating the return.

The public market signals over-pricing

Feld published his remarks recently in a blog under the headline " The Disappearance of Risk…..?" He divided the risks in investment in technology companies into two main types: "the company not reaching product-market fit and the management not being able to scale the business when product market fit was reached." In the past, he wrote, "It was rare to see a company that had not found demonstrable product-market fit raising capital at a valuation above $50 million. Today, companies that still have not found product-market fit are raising $50 million at valuations well in excess of a few hundred million."

That this is a distortion is can be seen, Feld argues, in the public market. The median decline in prices of SPACs in relation to the price per PIPE share issued between April and November 2021 was 22%. The market caps of highly valued companies like Lemonade, Wix, Kaltura, and Fiverr have been cut by tens of percentage points. "The public market investors almost uniformly have been telling private investors that they are over-pricing their private companies," Feld wrote.

"Assets that were liquid should trade at prices that are higher than similar assets that are not," Feld points out, but this has not recently been the case with privately-held companies that have gone public, and whose shares have thus become liquid, through mergers with SPACs. "What the SPAC post-trading performance proves is that the private markets are paying an illiquidity premium, not an illiquidity discount. Once a company is traded, the valuation goes quickly below the private round valuation set by the PIPE investors who invested in the SPAC. Essentially, there is no risk premium for illiquidity; again, risk is ignored in setting the return," he observes.

Feld concludes: "This cannot continue for long. While I am not smart enough to time markets (who really is?), there is a thing called gravity….and gravity in markets can be ugly in times when risk goes up in a hot air balloon."

Traditional funds left behind

A senior source in the investment industry explained to "Globes" how this "hot air balloon" was created. "It stems from the matching interests of the big investment funds on the one hand and the entrepreneurs on the other. Venture capital funds raised billions of dollars for investment, but did not recruit many more partners to invest this money. This means that their annual number of investments will not grow, but each investment has to be larger in order to allocate the money raised at the desired rate.

"For their part, even for a fat check, the entrepreneurs will not agree to sell a larger slice of the company than they planned. This means that the funds and the partners 'compromise' on a sale of a smaller stake in exchange for a large rise in the valuation of the company. This enables the investors to sign a big check, as the terms of the fund oblige them to do, and at the same time enables the entrepreneurs not to sell too large a chunk of the company. The result is inflation in company valuations, loss of efficiency of the money, and a disconnect between the amount of capital raised and the budget originally planned for the company. This is pushing money onto the companies, which are raising capital not according to their needs, but according to how much the funds have to invest."

In the nature of things, the giant funds are shoving the traditional venture capital firms, such as Vintage, Viola, Pitango, Bessemer and Lightspeed, aside. These veteran firms have operated in the same way for almost thirty years: they raise a few hundred million dollars for investment in technology companies, disburse the money among ten or twenty companies over twelve to fifteen years, and are measured by their annual returns.

Sam Lessin, formerly a vice president at Facebook and one of the founders of the technology blog "The Information", has argued that the historic role of the traditional venture capital firms in supporting software companies has come to an end. The level of risk in these companies has substantially fallen, and venture capital should be supporting companies in riskier sectors such as life sciences, space and cleantech, he argues.

It's not at all certain that he's right, considering the problematic record of venture capital firms that have gambled on cleantech, such as Kleiner Perkins and Khosla Ventures. It could be that the expertise of venture capital firms in software will help them in investing in such applications.

"In the end, the true function of the traditional venture capital firms is not to invest in technology, but to generate returns for investors," says another investor. "If there's a less risky field of investment, it's far preferable to us."

Potential entrepreneurs locked into unicorns

To fight for their slice of the growth companies, the venture capital firms have set up private equity arms. But to preserve their added value, they have been pushed more and more to investment at the seed stage, the stage of the initial product, when the company still hasn't much to show, and the investment is mainly based on the entrepreneurs' assessment of the market potential. The supply of such companies, however, is dwindling.

In 2014, 1,400 new startups were founded in Israel. The annual average is now around 520. That is not necessarily a bad thing. Although a large number of startups were founded that year, their quality did not turn out to be particularly high. The returns they gave Israeli investors were among the lowest in recent decades.

Nevertheless, the decline in numbers is a sign that many potential entrepreneurs, as good as they may be, prefer to continue working where they are, in unicorn companies or in the development centers of high-paying international companies. If, ten years ago, entrepreneurs would found companies, sell them after a couple of years for tens of millions of dollars, and move on to the next company, today they are "imprisoned" in unicorns whose exit horizons are much longer, and where the profit potential is substantially higher.

"The decline in the number of new companies stems from, among other things, the good working conditions at the companies," explains Dr. Ayal Shenhav, head of law firm Gross & Co.'s Hi-Tech and Venture Capital Practice. "Employees receive high salaries and rewarding conditions, which means that the price of leaving in the middle to found a company is very high for them."

According to Startup Nation Central, the number of seed rounds in new companies fell from a peak of 361 in 2018 to 188 last year. The total amount invested in these rounds has risen, but the rise is small in relation to financing rounds at later stages. "Many funds are saying to themselves that they will invest more at a higher valuation and take fewer risks at the seed stage, and so a situation comes about in which the amount of money at this stage declines. In part, this is connected to legislation that does not encourage investment at these stages, by contrast with the practice in the US, where there are substantial tax benefits for angels (private investors at early stages)," says Dr. Shenhav.

2021 turned out to be a year in which the potential income of technology workers and investors from selling shares and exercising options was much higher than income from salaries. Since the beginning of 2020, some $6-7 billion have passed into the hands of high-tech workers in Israel in options, out of about $30 billion available to them for exercise and sale.

It isn't just the workers. Partners in venture capital funds are benefitting from success fees on sales of portfolio companies, after the lion's share goes to the limited partners. Even when the risk is low, the workers and partners will continue to benefit from a low capital gains tax rate of 25% this year and next. The Israel Tax Authority's plan to raise tax rates on success fees of partners in venture capital and private equity funds were ultimately shelved, but the Authority has not given up, and it will try to promote the measure as a separate law this year,

It could be, however, that the second half of 2020 and the first half of 2021, in which we saw the peak for investment in technology, represent a one-time event in which the consequences of the coronavirus pandemic, zero interest rates, and low inflation came together. It's by no means certain that the risk has disappeared for ever, and 2022 could mark its comeback.

Published by Globes, Israel business news - en.globes.co.il - on January 2, 2022.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2022.

Isreali tech company Aquant  credit: Shlomi Yosef
Isreali tech company Aquant credit: Shlomi Yosef
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