Advice to Rising VCs and Founders Navigating The Correction
By Revolution Ventures Managing Partner David Golden and VP Alex Shtarkman
Given the tumultuous year in tech and overall market uncertainty, a hot topic among institutional investors right now is the magnitude of potential markdowns in the coming year or two. But what could that look like? To determine approximately how many U.S. VC dollars are at risk, we conducted a historical analysis of top quartile fund managers over the past quarter century (as far back as we could access reliable Cambridge Associates data). We looked at the analysis in two parts: the 1997–2010 time period and the 2011–2020 time period. This post highlights what has happened and what might be coming for investors and founders.
1997–2010
The chart above captured fund vintages that were fully-seasoned and had distributed most of their holdings. We noticed that, for those vintages, the average DPI (i.e., cash-on-cash returns) was approximately 1.5x — meaning these top quartile funds returned on average about 1.5x the amount that investors contributed to their funds, net of all management fees and carried interest paid to the GPs.
2010–2020
We then looked at the top quartile fund performers for fund vintages since 2010. If one assumes that “the trend is your friend,” it is reasonable to conclude that when all of these funds mature, they too will distribute on average 1.5x for every dollar invested (net of fees and carried interest).
However, the chart above identifies considerable gaps between the actual distributed proceeds (to-date) and the total marked value of paid-in capital (TVPI) for the funds represented in each vintage year, or how much VCs claim their portfolio is currently worth. Of course, some of that difference is explained because these funds are younger, less seasoned, hold less mature companies, and have accordingly not monetized yet. Over time, one would expect the two bars to converge for each fund vintage year (as they did in the first chart above), as the value of the portfolio is converted to distributable proceeds. In an ideal world, the DPI, the money paid to investors, matches the TVPI, the amount investors estimated the portfolio would be worth. If the “marks’’ in the portfolio are reasonable, they should convert to cash and be distributed to investors over time.
A More Detailed Picture Emerges
So far, so good. But what’s really interesting is how much the TVPI has exceeded the 1.5x DPI historical average for top quartile funds over the last decade or so (see chart above) — the variances between the two bars have materially diverged from what we would expect to happen if recent vintages perform like older vintages.
From here, a picture starts to emerge of how many dollars are at risk inside some top quartile portfolios because the “marks” or value assigned to companies’ value in the portfolio, are higher than the long-term expected cash value of the fund’s portfolio based on the historical average. While it is difficult to accurately predict how many VC dollars deployed each year were deployed by top quartile funds and how many of those investments were “marked up” in a given year, we can still safely assume that the total value of potential markups at risk is material. The blue bars represent the value that is likely to evaporate from future markdowns (reductions in estimated value) across the top quartile funds (i.e., those marks above the historical 1.5x DPI average), translating roughly to $1.2T since 2011. Said another way, if the top performing venture funds of the past dozen years mirror the performance of the prior dozen years, one should expect approximately $1.2T of value deterioration in the next several years because the current carrying value of the portfolios is substantially greater than the expected value of the portfolios based on long-term historical trends.
So what does this mean for venture capitalists?
For a VC, if a fund has valued its portfolio appropriately, there is not much to worry about. But if the fund relies on a “momentum” investing strategy (a strategy that is dependent on the next investor simply investing at a higher valuation than is supported by the fundamentals of the business because of an assumed upward trend) it is likely that those marks will be reset as the market inevitably corrects. The impact has already been felt by many late stage venture investors, as their portfolio valuations tend to be tied more closely with public market comparables, which have reset in the past several quarters. But as night follows day, many early-stage VCs will experience the same correction in the coming quarters. While it would be tempting to defer those valuation adjustments (by extending runway through instruments such as SAFEs and convertible notes or internal rounds funded entirely by current investors at the last valuation), the history chronicled above has shown that the pain may be deferred, but it certainly will not be eliminated.
And what does this mean for founders?
For founders, valuation resets often mean “down rounds” where unrealized employee wealth evaporates seemingly overnight, with the corresponding morale problem. If a company does not need to raise additional capital, the only “forcing function” will be the periodic setting of stock option strike prices for new option grants. In the absence of an arms-length fundraising event, such common stock valuation exercises (often performed by third party firms as part of an annual 409A valuation) are generally pretty benign. For companies in this position, the only valuation that matters is the eventual IPO or sale.
On the other hand, if the company does need to finance again, it is likely looking at a “down round” in the near future — a financing at a lower price per share than the previous financing. That financing will be more dilutive than one at the prior round’s valuation (exacerbated by anti-dilution adjustments where current investors in the company get some protection from the contractual issuance of even more shares to “make them whole” for the dilution from new investors), and it may have a negative impact on employee morale if their previously-granted options are “underwater” (i.e., with an exercise price per share greater than the new fair-market value price per share). There are many ways to address those employee issues — granting new options, repricing the old options, establishing management performance incentives that are separate from equity ownership — but these mechanisms do not fundamentally change the reality: the company is simply worth less than it was valued before.
Valuation adjustments are uncomfortable, but they do not have to be fatal. As we have discussed with management teams and boards over the years, it is easy to find a company that failed because it ran out of cash. But, we have never seen a company that failed from dilution.
