VC Optimism Returning But More Pain Ahead In Their Portfolios

Ok, this is the “For VCs, There’s More Pain Coming” post that I promised earlier (while also suggesting it’s actually a GREAT time to start a company). Obvious caveats to my POV here, most specifically: exposure is limited to largely the US/SiliconValley ecosystem, driven by our own portfolio, my friends and co-investors, the funds I’m a LP in, and our institutional LP relationships. But since this is vibes > data anyway, I’ll start with a story from Homebrew’s 2023 Annual Meeting.

Satya and I were having lunch (yummy Chinese food) with our LPAC and the conversation turned to generally “how much more did venture portfolios have to fall before they found their true current value?” That is, for the class of funds institutional LPs tend to back, on average, where was bottom? Each underlying firm has its own ‘valuation policy’ and we can have a separate conversation about the quality of those estimations, but you can generally assume that (a) there’s no real incentive for established VCs to be out of line with their view of reality (this stuff gets approved by accountants) and (b) LPs see this across a variety of managers and are sophisticated enough to apply their own modifiers to the numbers they are provided.

At the time, this is last quarter and the stock market has trended upwards nicely since then (a potential leading indicator of private tech valuations), we all agreed venture portfolios were probably still 25-40% overvalued. That’s a big number, one which if accurate moves many funds to at/below their target return goals for at least the moment! Our estimates were not out of line with new data from top firms like USV who, according to reports, “marked down the value of seven of its funds by nearly 26%.”

What are my major assumptions for why there’s more markdowns to come in the aggregate for the last decade of venture portfolios?

  • Valuations. The number of startups who raised money beyond the ‘Unicorn’ benchmark grew so dramatically before the 2022 reset that there is just simply farther to fall when many of these fail to grow into their targets, or disappear completely. The capital piled into them also transformed them, asking them to grow faster, spend more, and so on. These mutant unicorns may not recover without dramatic changes to culture and strategy, not just spend.
  • Fund Sizes Got Too Big. Firms raised too much money. I’m not crying for them – it’s their fault and they’re getting paid hefty management fees even if they’re mediocre investors – but greed and/or competitive pressure (plus an influx of new LPs) caused many VCs to have fund sizes which outpaced their capacity to deploy prudently and their existing strategies.
  • Restructures, Down Rounds, and Pay to Plays. Whatever gets reported is just the tip of the iceberg. The reality is lots of companies – many of them quite promising – have already undergone, or will be facing, next financings which “clean up” old cap tables. Often not all insiders have the dry powder to protect their positions, or feel the juice isn’t worth the squeeze. Sometimes these are led by outside investors and old ones will just take the impact and walk away. Regardless, even in rounds with no punitive structure, the quickest way to underperformance as a fund is by increasing your ‘dilution before exit’ portfolio model assumptions by 1000-5000 basis points. And that’s what’s happening here.
  • Soft Acquisition Market. Chilling effect of FTC action on major tech M&A combined with public company shareholders wanting their companies to maintain/grow profitability versus spend on what could be still overpriced assets. As The Information proclaims, “Unicorn Fire Sales Ahead.” At the lower end of the market, acquihires aren’t returning much to the cap tables and others are carving themselves into pieces to find buyers (and cash).
  • Many VCs Owned Too Little of Their Portfolio Companies to Begin With. When markets were at their peak the discipline around ownership felt antiquated to some, or at least challenged by the competitive realities. So when great exits again return to the $1b, $3b levels instead of everything being $5b-$50b on paper, it causes a lot of pain. As I wrote about last year, this is a huge (but not unexpected) change to models. Quite simply, on a $10b outcome everyone eats, but on a $1b outcome only concentrated investors see enough back to move the needle and/or those investors who got in early and keep their fund sizes reasonable. The growth in fund sizes plus the decrease is outcome size coupled with ownership challenges is a disaster. When the company exits you’ll get all the ‘congrats’ but you’ll know the DPI doesn’t match up. Let me tell you *every* credible VC fundraise deck I’ve seen this year talks about the importance of ownership concentration.
  • More Than Average (ALLEGED) Fraud. If not in number of companies, then seemingly in the amount of capital they were able to raise before getting exposed.
  • Overweighted in Speculative Crypto and Weren’t [Slimy or Smart depending on your POV] Enough To Get Out Before The Shitcoin Collapse.

So yeah, it’s gonna be a tough vintage of returns for many but hopefully healthy for our industry. Lower performing VCs will disappear faster and new entrants will differentiate themselves. Funds will get rightsized, which helps better align investors and founders in what defines a successful outcome. And fascinating new advances (and needs) in AI, climate, biology, etc are driving tech-IP driven startups.

The folks I feel for here are teams, who are going to continue to see layoffs and company wind downs, and the majority of founders who did nothing but responsibly play the hand they were dealt.