Has Venture Capital Become Too Safe?

2021 saw a 1.4-fold increase in venture capital invested in private Israeli tech companies. The number of active unicorns has tripled and the median valuation of companies raising funds has doubled from $ 20 million in 2020 to $ 40 million last year.

Suddenly, perhaps thanks to the coronavirus pandemic, investing in technology has become a standard financial transaction, 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 the technology has long since become mainstream. But does this mean that the element of risk has disappeared from investing in the sector?

“With the exception of 1999-2001, venture capitalists have generally built risk into their transactions,” wrote Alan Feld, founder of Vintage Investment Partners, one of the world’s largest and oldest private equity firms. -risk in Israel. Today, according to Feld, there is no risk premium in investing in private technology companies and risk is no longer a factor in calculating 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 of investing in technology companies into two main types: “the business not achieving product-to-market fit, and management not being able to scale the business when the business changes. ‘product-market fit was achieved’. In the past, he wrote: “It was rare to see a company that had not found a demonstrable product-market fit to raise capital at a valuation above $ 50 million. Today, companies that still haven’t found a product-to-market fit are raising $ 50 million at valuations well over a few hundred million. “

The fact that this is a distortion is visible, argues Feld, in the public market. The median drop in SPAC prices compared to the price of the PIPE share issued between April and November 2021 was 22%. The market caps of popular companies like Lemonade, Wix, Kaltura and Fiverr have been cut by tens of percentage points. “Public market investors have almost uniformly told private investors that they are overvaluing their private companies,” Feld wrote.

“Assets that were liquid should trade at higher prices than similar assets that are not,” Feld points out, but this has not been the case recently for private companies that have gone public and whose shares thus became liquid, through mergers with the PSPCs. “What PSPC’s post-trade performance proves is that private markets pay an illiquidity premium, not an illiquidity discount. Once a company is traded, the valuation quickly drops below. the valuation of the private tour set by the PIPE investors who have invested in the PSPC. Essentially, there is no risk premium for illiquidity; again, risk is ignored in determining the return, “observes he does.

Feld concludes: “This cannot go on for long. While I’m not smart enough to time the markets (who really is?), There is a thing called gravity… and gravity in the markets can be ugly when risk increases in a hot climate. hot air balloon. “

Traditional funds left behind

A senior source in the investment industry told “Globes” how this “hot air balloon” was created. “It stems from the matching of the interests of large investment funds on the one hand and entrepreneurs on the other. Venture capital funds have raised billions of dollars to invest, but haven’t recruited much more. partners to invest this money This means that their number of investments will not increase, but each investment must be larger in order to affect the money collected at the desired rate.

“For their part, even for a big check, entrepreneurs will not agree to sell a larger share of the business than they expected. strong increase in the valuation of the company. This allows investors to sign a big check, as the conditions of the fund require them to do, and at the same time allows entrepreneurs not to sell too much of the business. the result is an inflation of company valuations, a loss of efficiency of money and a disconnection between the amount of capital raised and the budget initially planned for the company. but depending on how much funds have to invest. “

In the wild, giant funds are shaking up traditional venture capital firms, such as Vintage, Viola, Pitango, Bessemer and Lightspeed. These seasoned companies have been operating the same way for almost thirty years: they raise a few hundred million dollars to invest in technology companies, distribute the money to ten or twenty companies over twelve to fifteen years, and measure themselves by their returns. annual.

Sam Lessin, former vice president of Facebook and one of the founders of the tech blog “The Information,” argued that the historic role of traditional venture capitalists in supporting software companies has come to an end. The level of risk in these companies has dropped significantly, and venture capital is expected to support companies in riskier industries such as life sciences, space and cleantech, he says.

It’s by no means certain that he’s right, given the problematic track record of venture capitalists that have gambled on cleantech, such as Kleiner Perkins and Khosla Ventures. The software expertise of venture capital firms may help them invest in such applications.

“At the end of the day, the real function of traditional venture capitalists is not to invest in technology, but to generate returns for investors,” says another investor. “If there is one area of ​​investment that is less risky, it is far better for us.”

Potential entrepreneurs locked in unicorns

To fight for their share of growth companies, venture capital firms have set up private equity branches. But to preserve their added value, they have been increasingly pushed to invest at the seed stage, at the initial product stage, when the company does not yet have much to show, and the investment rests. mainly on the appreciation of entrepreneurs. market potential. However, the supply of these companies is decreasing.

In 2014, 1,400 new startups were created in Israel. The annual average is now around 520. That’s 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 decades.

Nevertheless, the declining workforce is a sign that many potential entrepreneurs, however good they may be, prefer to continue working where they are, in unicorn companies or in the development poles of well-paid international companies. If ten years ago entrepreneurs started businesses, sold them after a few years for tens of millions of dollars, and moved on to the next business, today they are “trapped” in unicorns whose horizons exit are much longer, and where the profit potential is significantly higher.

“One of the reasons for the drop in the number of new businesses is good working conditions in companies,” says Dr Ayal Shenhav, director of the law firm Gross & Co. Hi-Tech and Venture Capital Practice. “Employees receive high salaries and rewarding conditions, which means that the price of going mid-career to start a business is very high for them.

According to Startup Nation Central, the number of rounds in new businesses has risen from a peak of 361 in 2018 to 188 last year. The total amount invested in these towers has increased, but the increase is small compared to funding rounds at later stages. “A lot of funds think they’ll invest more at a higher valuation and take less risk at the seed stage, and that results in a situation where the amount of money at that stage goes down. This is partly related to the legislation that does not encourage investment at these stages, unlike the practice in the United States, where there are substantial tax advantages for angel investors (private early stage investors) ”, explains Dr Shenhav.

2021 turned out to be a year in which the potential income of tech workers and investors from selling stocks and exercising options was far greater than income from wages. Since the start of 2020, some $ 6 billion to $ 7 billion has passed into the hands of high-tech workers in Israel in the form of options, out of about $ 30 billion available for exercise and sale.

It’s not just the workers. Partners of venture capital funds receive success commissions on sales of portfolio companies, after the lion’s share goes to limited partners. Even when the risk is low, workers and partners will continue to benefit from a low capital gains tax rate of 25% this year and next. The Israeli tax administration’s plan to raise tax rates on partner success fees in venture capital and private equity funds was ultimately scrapped, but the administration did not give up, and she 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, during which we saw the peak of investment in technology, represent a one-off event in which the consequences of the coronavirus pandemic, interest rates zero and low inflation met. It is not certain that the risk is gone forever, and 2022 could mark its return.

Posted by Globes, Israel business news – en.globes.co.il – January 2, 2022.

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

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