Let’s start with some industry math. 5% of venture capitalists make the majority of the profit. What about the other 95%? Many fail to return principal, let alone hit the industry target of 18% IRR. Is this the crowd you want to follow with your investment thesis?
Warren Buffett loves to advise that smart investors are buying when others are selling and selling when others are buying. Why? Because most investors have the math wrong. Too many invest with emotion or a false sense of conviction…often influenced by CNBC, Twitter or even TechCrunch.
We start the post with this overview specifically because the latest hype is that venture capital is slowing down, the sky is falling, and so forth. TechCrunch has run a number of articles including: Need Advice On Navigating A Tough Startup Market? or The Venture Slowing Isn’t Coming. It’s Here. Private Equity News ran a bit more data-oriented piece entitled: Venture Capital Market Sees Funding Levels Drop While Valuations Rise.
Amidst the noise, we want to present a few counter-points for investors, and entrepreneurs, to consider. First, while it is true that easy money supply has injected lots of excess cash into the market, which has in turn led to more capital for private investments, almost all of this capital flows to institutional investors who are mostly focused on later stage, large rounds. The metrics of capital investment at the Seed and Series A stages of investment have steadily grown over the last decade and almost never deviate from the upward trend line much. When you see large jumps or drops in venture investing activity from one quarter to the next, simply look at the later stage deals / larger rounds and you’ll see where the movement happens.
Second, realize that a lot of the media coverage around venture investing is focused on pure tech. There is a slightly larger correlation between pure tech venture investing levels and the broader capital markets in part due to the fact that the capital markets are heavily influenced by BIG tech company performance. Over the last half decade, the “FANG” stocks have driven a lot of the media coverage and market volatility. Don’t let any of that distract you from the reality that early stage healthcare investing volatility is extremely low over time.
Finally, where investment dollars are going is a horrible macro signal to follow. It has a lag built in. It’s even worse than following macro economic reports. Once news media report that the metrics of the economy show we’re in a recession, we have actually been in that recession for a number of quarters. Historically it means we are closer to the recovery and bull market than we are to the start of the bear.
Let’s use a few specific examples of early stage companies and how they are not impacted by the hype news mentioned above. LightLine Medical is a urologic device designed to prevent infections. The success of the product, and underlying company, is tied to the need to reduce infections in urologic procedures. So, regardless of the micro trends going on in the funding market, an investor has to assess a few simple, fundamental question: “Do I think the market for this product is going to go up or down over the next few years? Is there any correlation to the success of this venture and the relative scarcity or abundance of capital in the market?” One of the key attributes of investments of this type, is their lack of correlation to the external market.
Consider a second example. Tear Solutions is addressing the growing problem of dry eye. Their initial studies are showing great promise over the current market options. Again, an investor has to decide whether there is any impact to a potential investment in a company like this and the relative availability of capital. The data tied to a growing senior population, and the increase in dry eye issues, would likely indicate a strong demand for years to come. Is there any valuation sensitivity tied to capital availability? Maybe, but not likely of any significance at these early stages. When the bulk of early stage capital is coming from non-dilutive grants, angel capital and smaller VC funds, the tie to broader increases or decreases in institutional money is pretty low.
It’s also worth noting that both companies are run by very savvy entrepreneurs. In the end, early stage ventures like this are far more correlated to the skill of the team than any external financial market condition.
Is there correlation between venture capital pace and volumes for early stage companies? Maybe. But, if there is any, it’s likely minor and its real use would have been several quarters before you are actually reading about it. As investors, there are far far more important characteristics to focus on, despite what the media pundits want you to think.