Why venture capitalists are hitting the pause button on tech investment

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Tech investors and startups alike had hoped the new year would bring a revival in venture investments and initial public offerings that began slowing down last year.

No such luck. According to two new reports this week, and likely a third report due out next week, both venture-backed investments and IPOs are continuing to fall. That’s despite a pretty favorable environment marked by a rising stock market, falling unemployment and upward revisions in gross domestic product numbers.

“We’re taking a pause,” said Bob Ackerman, founder and managing director of Allegis Capital. “People are wondering: Are we near the top, or past the top?”

Most of the numbers clearly suggest the latter. Venture investors funneled $16.5 billion into 1,797 startups in the first quarter, but that was the smallest number of companies since late 2011, according to the PitchBook-NVCA Venture Monitor report issued Wednesday by the National Venture Capital Association. The biggest shortfall was angel and seed deals, which fell 32 percent, to 827. And first-time financings plunged to just under 500, the fewest in a quarter in nearly seven years.

Source: PitchBook/NVCA

Source: PitchBook/NVCA

What’s more, VCs’ own fundraising declined. Although VC firms raised $7.9 billion across 58 funds in the first quarter, that was down 24 percent from a year ago.

On the IPO front, things look even worse. Despite a number of successful recent IPOs from MuleSoft Inc., Alteryx Inc. and today Okta Inc., and more coming from the likes of Cloudera Inc., the numbers remain small: only four tech companies and 27 overall in the first quarter, according to a report earlier this week from PricewaterhouseCoopers. Although that was much higher than the 11 overall a year ago, it was still the second-slowest quarter in six years. David Ethridge, head of PwC’s U.S. IPO services, said he expected to see up to 15 tech IPOs in the quarter.

Moreover, tech executives say that some companies are going public only because they couldn’t find a corporate buyer willing to pay up for their stretched valuations. AppDynamics Inc., which was poised to be the first tech IPO of 2017, instead sold to Cisco Systems Inc. in January for $3.7 billion, but others haven’t been so lucky. For those, said Yaron Haviv, chief technology officer at big data startup Iguazio, “It’s like now or never.”

Source: PricewaterhouseCoopers

Source: PricewaterhouseCoopers

The slowdown in venture investing and IPOs raises concerns about whether tech’s long period of prosperity could slow down even more, taking innovation down along with it. Venture investment, IPOs and acquisitions fuel the growth cycle that Silicon Valley and tech at large depend on to fund new technologies, and when that cycle turns downward, the potential is that, as Ackerman puts it, “curing cancer doesn’t get funded.”

But some VCs think we’re seeing a fundamental, welcome change in tech investment after several years of seemingly never-ending escalation of funding rounds and valuations, especially of “unicorns” such as Uber Technologies Inc. and Airbnb Inc. “We’re moving into the post-steroid era of venture capital,” Tim Connors, founder of PivotNorth Capital, said in a recent interview with SiliconANGLE.

Indeed, the era of unicorns — companies valued at a billion dollars or more — may be winding down. “What we’ve seen in the last couple of months is that not all unicorns are unicorns,” said Ackerman. And while the crazy valuation level of some companies may have been obvious to many people for awhile now, he said, “that trickles down to the rest of the ecosystem,” deflating valuations of smaller companies as well.

Many venture capitalists say they welcome what they call a new “discipline” in investment, though it’s not hard to hear the whistling past the graveyard. “We had some big, big years in 2015 and 2016,” said Venky Ganesan, managing director at Menlo Ventures and chair of the National Venture Capital Association board. Now, he said, “it’s more like a digestion period.”

Enterprise bucks the downward trend

Some companies, especially in enterprise software, are managing to buck the downward trend. Cloud data warehouse supplier Snowflake Computing Inc., for instance, this week raised a huge $100 million Series D round. “The sky is brightening a little bit,” said Snowflake Chief Executive Bob Muglia.

At a time when the valuations of consumer Internet companies have gotten into nosebleed territory and a shiny new object hasn’t yet emerged post-Snap Inc., investors may view enterprise technology companies as something of a safe haven. In a December survey of 600 investors conducted by SharesPost Inc., which arranges sales of stock in private companies, the majority of respondents indicated a preference for enterprise software companies. “Enterprise is steady, so when people can’t find a great consumer company [to fund], they go back to enterprise,” said Ganesan.

Even more specifically, investors can’t get enough of some hot areas of enterprise technology, such as cybersecurity. Alberto Yepez closed an oversubscribed new fund, Trident Capital Cybersecurity, in January, raising double the $150 million he had initially planned, and has already made five investments. “We’re not seeing a slowdown,” he said. “Cybersecurity is actually accelerating,” thanks to daily reports of breaches and fraud.

VC investment levels and IPOs aren’t the only potential wrench in the tech innovation flywheel. One factor the VC and IPO numbers don’t capture is the potential for immigration limitations by the Trump administration to discourage talent from coming to the U.S. As former New York Times reporter John Markoff put it in a recent interview with SiliconANGLE: “One of the key aspects of Silicon Valley is it was a magnet for the best and brightest from the entire world. If you basically block that, if people go to China or they go to Europe, the chemistry falls apart.”

It’s a real danger, said Ganesan. “H-1B visas are the most critical conduit for talent,” he said, though he added that “the Trump administration’s bark has been worse than its bite.”

Nonetheless, the Pitchbook/NVCA report called out the issue. “The longer visa process for foreign-born founders has put a strain on company growth and in some cases prevented foreign-born founders from securing funding due to visa status,” the report said.

And more generally, uncertainty about the new president’s policies remains a potential drag: “Recent developments from the Trump Administration and uncertainty stemming from future unknowns remain an X-factor in both the short- and medium-term for venture investors.”

Ultimately the fate of startups is in their own hands, though. “The message to entrepreneurs is: Build businesses with strong fundamentals,” said Yepez. “There’s money available for them.”

Photo: Pixabay