Why The Traditional Venture Model Is Poised To Underperform And Venture Development Is The Antidote

As an investor, it is important to understand the underlying trends in your specific industry. Personally, I believe traditional venture investing is poised to underperform in the years to come for four fundamental reasons:

1. Significant capital inflow into the VC industry while the number of deals is in a steep decline.

In 2017, there was $84 billion invested in deals, which is the most since the Dot-Com era. We’ve seen an 87% growth in deal value since 2013, and since the 2015 peak, the number of deals has decreased by 23%. The decline for earlier stage deals is a staggering 50% since peaking in 2014.

As a value investor, analyzing how capital flows in and out of an asset class is crucial for understanding impact on valuation and future performance. As indicated in the graph below, VC funds raised $143 billion since 2014 -- that is a staggering number!

Clearly, the VC industry is taking in capital at a faster rate than it can deploy, and has reached a “natural capacity,” which is causing deal value and valuation expansion.

2. Significant increase in deal value

The dramatic inflow of capital into the industry coupled with the decrease in number of deals has directly impacted deal size. As money started to flow quickly into the space, deals with $50 million or more began to take up a greater piece of the industry, reaching more than 50% in 2017.

There has been discussion in the industry regarding the rise of mega rounds to fund unicorn activity, but the reality is that deal values are increasing across all stages of funding not just in unicorn activity. According to a recent post by Crunchbase, early-stage deal value is growing at a faster pace than late-stage deals.

While overall deal values are increasing, there has been accelerated growth in the average or the mean of deal values. Over the course of the last decade, the mean deal value remained stagnant at $6.86 million. In 2014, we started to see a steady climb of deal value with $7.58 million in 2015, $8.48 million in 2016, and an all-time high of $10.42 million in 2017. The numbers represent a 10.5%, 22% and 52% increase over the mean per year respectively and were far above the 2008 levels.

3. Record high valuations

As early-stage deals are becoming scarce, and the size of deals are growing substantially, what is happening to valuations? According to an annual survey performed by TrueBridge Capital, leading Seed and Series A investors found that:

• As of September 2017, Seed stage company valuations climbed and the median pre-money valuation of Seed stage companies reached $6 million -- the highest it has been since 2008 pre-financial crisis levels.
• The median pre-money valuation for Series A companies has steadily grown since 2008 to almost $16 million, and for Series B companies the median has doubled to $40 million.

VCs are stacking the deck on fewer albeit more developed deals, and with more money to deploy, valuations are growing at a similar rate.

4. Steep decline in exits

The current VC industry is facing a significant supply of capital, concentrated deal flow, all-time high average deal size and by estimate, pre-financial crisis valuations. At the same time, the number of exits continue to decrease.

Both exit values and number of exits have retreated to 2012 levels, while capital inflow, deal value and valuations are at a decade high.

This explains why $19.2 billion was invested in 73 unicorn deals in 2017 -- 1% of deals took a staggering 23% of all VC investments. As exit markets continue to soften, more and more capital is being deployed to keep private deals funded as they wait for their exit window to arrive.

This reminds me of a game of musical chairs. This game works well until the music stops playing ... just ask Charlie Prince, ex-CEO at Citi.

These four key factors have created a significant fundamental mismatch in the VC industry, and are clear indicators that future return for traditional venture is poised to suffer.

On the latest letter to Berkshire shareholders, the Sage of Omaha writes a cautionary note to investors: “The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” Sage advice indeed.

Venture Development - The Antidote

At Ikove, we dove into the data and industry trends, and built an investment model that focuses on what we’ve coined as “Venture Development.” Our objective isn’t to write a check, take a minority passive position and hope it all works out.

1. We go to the source

Ikove is actively pursuing technologies that have been developed and reinforced by significant investments in R&D at leading research institutions.

As we identify disruptive technologies, we thoroughly vet them through our Startup Nursery. If it survives the vetting process, we then recruit talented CEOs and operators to be part of the founding cap table of the companies.

2. We are founders

Ikove is heavily involved in the launch and operations of the business alongside each company’s management team. We focus on deep tech businesses that solve real world problems. We are not investing or developing the latest trending app; we prefer to focus on disrupting industries all backed by strong and significant IP.

Our investors via our new Startup Nursery Fund (SUN Fund) will have access to founding equity in the companies launched, alongside Ikove, the management team, the inventor and the research lab or university. That makes all the difference as valuation is the key determining factor of potential return.

This implies founder level valuation and equity, which is extremely rare. Even our seed rounds are based on calculated valuations where a 20X or larger ROI can potentially be achieved with average size exits.

3. We focus where few are looking

By having our Startup Nursery headquartered in the Midwest, we have access to world class technologies, infrastructure and teams at a fraction of the cost of the coasts. And while we may be located in the heartland, we continue to make great strides in developing relationships worldwide. Our CEOs can relocate the companies where they see a strategic fit, so they have the lower cost benefits of being in the Midwest and valuation arbitrage as the operating business settle in places like San Francisco, NYC or Shanghai.

This implies less dilution for shareholders as we leverage the billions already invested to develop the technologies through universities, utilize the current infrastructure of the leading research labs and operate businesses at a much lower cost structure. Meaning we buy low and sell high, not the other way around.

4. We build to sell

We build our companies to be fast-growing, profitable businesses that can go all the way to become IPOs; but given current exit dynamics, we position our portfolio companies in such a way that they can be acquisition targets. We develop our companies with a clear “build to sell” focus.

Our Venture Development model means that by building founder level equity from the beginning we eliminate the risk of paying top dollar. We reduce dilution by partnering with large research institutions and by launching the companies in the Midwest. On the exit side, we can target 20X more without the need for mega exits.

Venture Development is venture done right, and is the antidote to the coming underperformance in traditional venture.

This insight was also featured on VentureBeat.