Interest Rates and Venture Capital

The Venture Capital market has experienced a massive growth in the last two decades. Startups prefer to get venture capital funding instead of raising debt. However, when it comes to economic growth, interest rates and Venture Capital (VC) go hand in hand. VC boost entrepreneurial activities and interest rates are helpful when it comes to risk-taking activities for the wellbeing of the economy.

If the interest rate is low, it serves as a fuel for VC investment, but at the same time, it discourages venture capitalists to put their money in riskier startups that are young, in other countries and in less popular industries.

Typically, VC firms invest their money after comparing the profits they achieve with profits that are available to the investors somewhere else. However, the relationship between interest rate and risk-taking can change based on which investor’s point of view is considered.

Effect of Interest Rate on non-traditional Capital

When we talk about short to medium term variations in the interest rate, it usually affects non-traditional capital source, including hedge funds and mutual funds. Unlike conventional Venture Capital investors, who keep their money invested for 10 years or so, unconventional investors can put their cash in different baskets and spread it across different assets classes. They can quickly decide where they should put their money in order to reduce the impact of interest rate variation.

Changing Effect of Interest Rate on VC Investments

Over the last three decades, federal rates have changed from as high as 16% in the early 80s to as low as 0.09%. However, VC has evolved from a small industry into a $100 billion per year asset class. Venture capitalists are investing a massive amount of money every year. Therefore, it is important to understand the changing effect of interest rate on VC investments.

Between the year 2000 and 2009, the federal fund rates and VC investments were parallel to each other. When the technology bubble was burst, the Federal Reserve adopted the strategy of decreasing interest rates so as to promote the economic growth. For venture capitalists, the environment was not as attractive as it was before and limited partners invested less in venture capital. The VC decreased with the decline in interest rates.

After the introduction of quantitative easing, this relationship between VC and interest rates ceased to exist and they became inversely proportional to each other.

Moreover, after the credit crunch, near-zero interest rate policy enabled financial institutions and brokerages to renew their balance sheets, settle their toxic assets, and revitalize their financial health. It also allowed the U.S. economy to recover from the after-effects of the crisis and enabled businesses to borrow capital at reasonable rates. During this phase of cheap money, technology sector, VC firms, and startups took advantage of the friendly valuation environment.

Federal Reserve’s Decision to Raise Interest Rates

By the end of this year, Fed plans to raise the interest rates. If the plan materializes, it will be the first time in the past nine years that the U.S. will experience the increase in rates, which will bring the era of zero interest rate to an end.

Chairman of the Federal Reserve, Janet Yellen, indicated that the increase in interest rates will not be rapid.

It will be a gradual increase, which will not change the valuation environment of a startup and technology sector instantly. However, it will change along with a valuation environment of the stock market. The reason is simple; valuation multiples are indirectly correlated to interest rates, where in, the multiples decrease with the increase in rates.

It is important to observe the next move of the Fed and market reaction to changing interest rates, because it may affect the Venture Capital market.

ICOs Surpassed Early Stage Venture Capital Funding

New startups that raised funds through Initial Coin Offerings (ICOs) have now surpassed the early stage VC Funding for internet firms.

But before diving into it, it is important to know what ICOs are.

What is Initial Coin Offerings?

This is another way of raising cash.

Cryptocurrency and blockchain startup companies raise capital through ICOs by selling tokens of investors in exchange for equity funds. It is somewhat the same as Initial Public Offering in which stocks are issued in exchange for equity. Just like crowdfunding, ICOs provide a way to get funds from users by enabling them to have a share of the business. They get digital currency in exchange for the money they invest in the business.

Rising Popularity of ICOs and VC Funding

ICOs have gained massive popularity in the last few months among blockchain and cryptocurrency startups. In April this year, the total capital raised via these offerings was around $100 million and in May, the amount went up to about $250 million. The month of June turned out to be the biggest surprise when the total funding exceeded $550 million. According to Goldman Sachs, it was the first time that it performed better than seed and angel venture capital funding. Early stage and angel venture capital funding was less than $300 million in June.

In July, the offerings were a little more than $300 million, whereas, early stage and angel funding was just a bit higher than $200 million.

Popularity Among the Celebrities

ICOs have become so popular that even the celebrities, including Paris Hilton and Floyd Mayweather, have started jumping on board. In fact, Paris has been involved in it for over a year now and also met the COO of Ethereum last year.

Total Value of ICOs in 2017

The total value raised by 92 ICOs in 2017 is $1.25 billion. This is a really good number, given the recent boom of such offerings in the VC sector. There are so many firms that have used these offerings to raise money. For example, Tezos managed to get the capital of over $200 million by creating a new blockchain, whereas, another firm, Bancor secured $153 million via ICO.

Criticism and Scrutiny from Regulators

Despite the boom, this phenomenon has been under severe criticism and scrutiny from regulators and other authorities. For example, the Monetary Authority of Singapore (MAS) released a statement in which it was mentioned that these offerings are exposed to money laundering and other terrorist financing risks, because the nature of these transactions remains anonymous. Another concern raised by the MAS was the collection of large amounts of capital in such a short time frame, which makes ICO vulnerable to high-level risk.

On the other hand, the Security and Exchange Commission (SEC) said in July this year that the security law of the U.S. will be applicable to this cryptocurrency. The experts are also showing concern over its legitimacy. They have highlighted that the sale of a cryptographic token makes the investor entitled to a certain share of profit in the firm, which can be considered as a violation of financial rules and regulations. The People’s Bank of China and a lot of other government departments have released a joint statement that people and firms that have raised money through ICO should also make arrangements to return that capital.

Firms Facing Increasing Risk of Getting Hacked

Despite all the boom and criticism, the risk of ICOs cannot be ruled out. A clear example of this is CoinDash that initiated an ICO, but ended up getting hacked in July. As a result, all of its funds got stolen. Although, it has gained popularity in the past few months, yet, the risks cannot be ruled out entirely.

Future of ICOs

The Chief Information Officer of UBS, Oliver Bussman, raised his concern and said that strict regulations and measures, as applied to IPO businesses, are required in ICO to safeguard the interest of investors. However, he is quite confident about this new mode of raising funds and expressed that such offerings will continue to happen in future. He said that as a new business model that is benefiting the blockchain technology, ICO will continue to sustain by combining hybrid equity ownership/currency and crowd funding.

Why Venture Capitals should back companies with female founders?

Although, venture capital has invested a huge amount of money in the IT sector and contributed to innovative developments, yet, it still faces the same gender equality problems as any other sector does. A study by the Babson College examined the state of women in the venture capital sector. Around 7000 companies that got venture capital (VC) funding were evaluated.

According to the study, the percentage of women partners in VC firms was 10 percent in 1999, but it has reduced to only 6 percent now and venture backed companies that have female founders make 12 percent more revenue than companies with male owners. Despite that, only 2.7 percent of the companies fueled by venture capital had female chief executive officers between 2011 and 2013. Whereas, according to a 2014 research report of the Fortune, only 4.2 percent of the partners are women in the VC sector.

Issues Faced by Women in the IT Sector

Women in the IT sector have initiated a number of campaigns that are based on ‘asking for more’, especially when it comes to STEM (Science, Technology, Engineering, Mathematics) education, fair policies, mentors, pay raise, and salaries. Moreover, women have also come forward with the hardships that include unfair salary negotiation and maternity leave policies and gender bias.

These issues have led to many campaigns, conferences, and summits. However, despite all these stories of hardship and inequality, no change has come. A clear example of this is a when Ellen Pao lost her case in 2015 for gender discrimination. She claimed to have been left out of networking events because she was a female and was not promoted to be a partner while her male colleagues were promoted ahead of her.

A partner at Canaan Partners, John Balen, said that the male dominating culture begins right from the school and there should be a conscious effort to break that cycle. Candy Brush who carried out the Babson College study is of the opinion that a journey toward becoming a venture capitalist starts from your college and professional network. If 2.7 percent of the firms have females at the executive position and 15 percent of the venture-backed companies have one female on their team, it represents the small possibility of it happening.

Macro Factors – The Cause of Decline in Female VC Partners?

As discussed, the percentage of female partners in VC firms have reduced from 10 percent to 6 percent since 1999. Macro factors, including a dot com bubble burst of 2000 and credit crunch of 2008 have also contributed to the decline. VC companies had to go for downsizing during those downturns. The majority of the firms were not so big; they had to lay off on the basis of “last in, first out” – minorities and females in this case.

Another macro factor was the rising popularity of the technology market during the past two decades, especially after Facebook and Google. Having a technological edge was what mattered the most. Although, there has been a shift in this attitude, yet, there are so many investors who still want a technical partner in their team.

The founder of Brooklyn Bridge Ventures, Charlie O’Donnell, said that there are only a few females who are software engineers, therefore, it automatically leads a firm to hire more male partners.

Can Gender Equality Lead to Business Opportunity?

The managing directors and co-founders of the Women’s Venture Capital Fund, Monica Dodi and Edith Dorsen, once had a rendezvous with finance and investment professionals to talk about the more risk-intelligent approach in the VC sector. Their fund is the outcome of that meeting. Dorsen was of the opinion that the purpose of initiating this fund was to explore the untouched opportunity with female founders as a focal point. She further went on to say that firms with gender inclusive teams tend to perform better and are very competitive, but not everyone fully understands it so as to generate return out of it.

In a research carried out by Babson college, it was revealed that companies with females in the executive team are 64 percent more likely to have better valuations after the first funding and 50 percent chance to perform better at the last funding.

The founder of the Female Founders Fund, Anu Duggal, said that she visits the Silicon Valley four times a year to interact with partners of the top venture capital funds. She has observed a shift in attitude with a positive change. If the current trend continues, the VC sector and technology market might experience a major shift and massive success in times to come as it moves in the direction of gender equality.

Evolution of the Venture Capital Sector

Venture capital (VC) industry is highly volatile. It is constantly evolving and has undergone massive changes in the past ten years due to the growth of the software sector. The shift toward the IT industry will continue to persist until one of the two situations occur:

Either the software market starts experiencing saturation as a result of huge inflow of money in the industry or
There is a manifestation of a new industry that shows higher profits, hence catching the attention of investors.

There are some analysts in the financial sector who are also anticipating another bubble bust that will be similar to the dotcom bubble in the 90s.

Rise and Fall in the VC Sector During the Past 5 Years

In 2015, VC investment around the globe experienced a growth of 19 percent. The total funding was between $128.5 billion and $130 billion, which has been the highest in the last 5 years. However, the investment continued to grow in the U.S. from $58.8 billion in 2015 to $69.1 billion in 2016.

As far as the rise of unicorn companies on a global level is concerned, it gradually declined after 2015 when the total number of startups that reached unicorn status were 71. The number reduced to 40 in 2016. On the other hand, a decline was also observed in seed funding as it dropped by 25 percent and touched the lowest point since 2012. The late and early stage investments also went down by 14 percent and 5 percent respectively.

Opportunities for VC Investors

Although, a large number of high profile investors pursue seed stage deals, they usually have sufficient funds to invest in the most attractive startup companies, which has subsequently strengthened Series A and Series B rounds.

Moreover, seed stage investments performed really well in 2014 and 2015, indicating the fact that investors who made those investments will be continuing in 2017. It will give rise to a great opportunity for investors who are seeking to make an investment at a later stage.

The momentum in the IPO will also increase, because the public sector tends to grow when valuations in the private sector are higher. It is quite likely that the IPO market backed by VC investors will outperform in 2017 as compared to 2016. For example, it has been reported that Snap Inc. is expected to offer its share at about $20 billion. If the offer materializes, it will be one of the largest VC backed IPO deal. In addition to that, Spotify, Pinterest, Dropbox and Uber are some of the names creating buzz in the IPO sector.

Rising Trends and Acquisitions

Artificial intelligence (AI) and machine learning have grabbed a lot of attention between 2015 and 2016, and they are likely to secure more investment in 2017 as well. There were more than 300 businesses that managed to raise early and seed stage funding in 2016, yet, approximately dozen secure funds at a later stage.

Moreover, a number of healthy acquisitions have also taken place recently. The examples include the acquisition of Movidius by Intel for $350 million and acquisition of virtual assistant developer Viv by Samsung.

Economics and Investors’ Behavior

There is a major role play of economics when it comes to VC investments. Since economics follow a cyclical pattern, it is highly likely that history will not be repeated nor will the unpredictable happen. Also, economics involves study of human behavior that contains an element of irrationality. This element enables us to anticipate the shifts in behavior of VC investors only to an extent of its repetition and history, but it cannot be predicted with full certainty.

VC investments change with the passage of time. As the inflow of funds increases in the software sector, it gives rise to increasing competition in the market, which eventually reduce the overall returns as several firms compete to maintain a customer base. It might also cause a shift in venture capitalist behavior in times to come if other sectors seem more viable.

All in all, the justification of a VC investors’ behavior can be summed up by saying that venture capitalists tend to go in a direction where the money flows.

Startups Worthy of Investment … or not

It seems like those days are long gone when venture capitalists used SPRAY and PRAY strategy in the hope that one of the startups in the entire portfolio would make it big.

In other words, it is about time that startup companies show their ability that they are worthy of the venture capital (VC) funds.

Decline in the Number of VC Funded Companies

The PitchBook released the first quarter of the 2017 issue in collaboration with the National Venture Capital Association (NVCA). The statistics presented in that report were based on the thorough analysis of VC activity in the United States. According to that report, $16.5 billion was raised by 1800 companies alone. PitchBook and NVCA also observed that even though the amount of investment in the Q1 of 2017 was a bit higher than the capital invested in the fourth quarter of 2016, the number of startups has dramatically decreased to its lowest level since the fourth quarter of 2011.

VC Investors and Entrepreneurs Exercising Caution

It looks like the VC sector is facing a gradual decline after experiencing effervescent days of glory back in 2015.

John Gabbert, the CEO of PitchBook, said that during the past few years, the VC activity managed to attain intensified growth in the United States and now it seems to be coming back to earth. He further added that it feels like startup founders and investors have started following a more disciplined approach to investing the funds and taking reasonable caution by adopting measures, such as due diligence. These activities are carried out to secure fair deals on both sides so that each party gets something good out of it.

Ernst & Young, a London based auditing firm, reported that companies in the United States raised about 41.3 billion dollars in 2,802 VC deals in the third quarter of 2016. The San Franciso Bay area represented a total of 916 deals having a value of 16.9 billion dollars.

Jeffrey Grabow, the leader of VC in the U.S. based Ernst & Young, said that VC funding has slowed down and there are various reasons for the declining trend. The prominent reason, however, is the fact that investors want the market to absorb the already distributed capital in the market. Momentum capital has reached a later stage of VC funding and injected capital in almost every that was available in the market. Therefore, it is about time to see how it all turns out.

Comparison of the Number of Exits

In spite of the huge funding to a limited number of IT companies, a lot of companies fueled by $9.05 billion worth of venture capital took an exit in the first quarter of 2017. This exceeds the combined value of the IT companies’ exits in 2006, 2008 and 2009. The situation is relatively close to how it was back in 2007. If the same trend and immensity of initial public offerings and acquisitions follow, 2017 will either reach the same figure of 2014, i.e., 39.74 billion dollars, or might exceed it. Only time can tell what is to come next, but it continues to happen at the same pace, it would probably exceed the value of 2014.

IT firms around the world continue to leave behind all other kinds of businesses that are funded by venture capital. According to the NVCA and PitchBook report, Initial Public Offering of Snap and acquisition of AppDynamics by Cisco has been ranked among the top 10 biggest exits of their types during the past 10 years.

Investments in VC Activity

California has left behind all other states in the United States in terms of the number and value of VC investments. A total of 560 investments was made in 556 companies, which were worth 8.3 billion dollars. As far as the number of investments was concerned, New York was ranked second with a total of 218 investments. Whereas, Massachusetts was in the second position in terms of investment value as it was slightly higher than 2 billion dollars. Although, there may be a rising trend in the remote work among startup companies, yet, the concentration of venture capital is still high in the Silicon Valley.

How Important is Experience in Venture Capital?

In the world of information and technology, innovation is a key factor that drives the economy. Media is filled with success stories of founders in the Silicon Valley. On the other side of it, however, stands the venture capitalists who help these entrepreneurs materialize their dreams into successful businesses.

The venture capital sector in the United States is considered one of the key sectors that contributed to its economic growth. With the passage of time, the industry has faced massive growth around the globe and there is an increasing competition among investors to make it big. Some of the famous venture capitalists of earlier times are Tom Perkins, Tommy Davis, and Arthur Rock. In addition to the capital, it was their investing knowledge and experience that contributed toward the expansion of a tech industry.

Do You Need Talent for Venture Investing?

The venture capital industry has continuously evolved during the past few decades, and with that, some contradictions are brewing in the market. For example, the investors who dominate the market claim that they know how to choose a winner who would experience the same success as Facebook or Twitter did, yet, they expand the horizon of their bets, hoping that at least one of these will make it big.

This gives rise to a question:

Do you need talent for venture investing?

If so, what would it be?

The answer to this is simple; no! You do not need any special talent. Accounting or financial modelling skills are useful for venture capitalists, but it is important to note that early stage companies are not the same as public markets. In fact, they are run by owners who are still paving their way to success. The only thing that counts is the experience and skill of people who have already worked with startups and are ready to do whatever the job demands. Moreover, there is a common perception in the market that venture capitalists with a huge network of proven founders are the right choice, yet, you cannot rule out the fact that proven founders tend to ask for big checks, which reduces the share of a limited partner. New venture capital firms, on the other hand, are hungry to win and have the drive to listen to what startups want.

No Transparency in the Venture Capital Market

The venture capital market is not transparent, which is good news for venture capitalists, but not for the general public. Venture capitalists usually put their cash in long term investments, due to which, their outcome is not immediately visible. Therefore, it is difficult to measure the success and failure of any investment in the short run. Only a few estimations are publicly made available to compare the relative performance of one venture capital firm against another.

European Investment Fund – Evaluating Venture Capitalists Performance

European Investment Fund (EIF) is one of the very few institutions that have great access to venture capitalist funds for many years. In a recent report by EIF, analysis was conducted on the activities performed by venture capital firms in Europe over the last 20 years. Between 1996 and 2015, there were more than a thousand startups that were fueled by 355 EIF backed funds. According to the report, venture capitalists who were investing for the first time performed equally well as venture capitalists (VCs) with broader knowledge and experience, especially when the economy is booming.

Experience and Skills Matter

However, the explanation given in the EIF report was quite ordinary as they claimed to have good skills when it comes to choosing venture capital funds. It was further stated in the report that even the new VCs that have their backing perform well. But it did not have the coherence with another conclusion they reached in the same report, i.e., venture capital firms that carry out investments for the first time give a worse performance when markets are not doing well and these are the times when experience plays a vital role in defining the outcome of any investment.

This gives rise to another aspect of VC investing that is opposite to the perception of the industry; selecting a winning startup during the times when markets are booming is something newbies do as good as the experienced ones do, yet, the real test lies in avoiding losers and this can only be achieved with experience and the right skills.

Is Funding Your Startup with Venture Capital Always the Right Choice?

With the rapidly growing tech-world, it has become quite common for startups to fuel their ideas with funds injected by venture capitalists (VCs). Whenever you pick up a business newspaper now, there is mostly something written about VCs or the early stage businesses that were funded by these investors.

But is it always the right choice?

In today’s fast pace environment, everyone wants to make huge profits as soon as they possibly can. However, as the old saying goes, “haste makes waste.” This is also true for businesses.

Although, venture capital investment may be a good choice for some businesses, yet, it comes at a cost of coping with high expectations held by these investors, which also results in many startups to fail. The fact is, new ventures do not need such investments all the time. Besides, simply because you are a tech-company, doesn’t necessarily means that you have to have your office in the Silicon Valley. There are many companies in the world of technology that grew organically and made it big. Though, the progress was slow, it was steady and made them even stronger as they made it to where they are today. One such success story is of the MailChimp. Started as a design consulting firm, providing email service as a side project, the company touched a revenue of $280 million last year in 2015.

Dan Kurzius and Ben Chestnut started the company in 2000. Some of their clients were demanding a solution to engage their customers by email, so they tweaked some old codes that were used for an unsuccessful online greeting card business. For the next few years, this project was run parallel to their main business. In 2006, however, they started having reservations. Having the entrepreneurial family background, both the founders were passionate about helping small businesses grow. Despite being in a critical state of its growth, they knew MailChimp was a low cost marketing channel for small scale business firms. So, in 2007, they packed up their web design business and shifted their entire focus to email service. So, what made it such a huge success?

Valuing What Your Customer Needs

Even when the company was fully focused on providing email marketing service to its clients, they faced a host of larger and better funded competitors, including Constant Contact.

What kept MailChimp retain its clients?

It was the trust their customers had placed in them. Chestnut said that it was their close connection with the customers that their rivals didn’t have. They knew what their customers wanted. They offered affordable services, which also allowed greater customization to cater the customers’ needs.
Learning to Make Money is More Rewarding than Spending it as a Startup

Co-founder of Basecamp, Jason Fried, said that you learn bad habits from raising money, for example, if you have some cash in your bank account, it makes you good at spending it. But on the other hand, if you have to earn it yourself, it makes you good at making it, which is a good habit for an entrepreneur to learn sooner than later in running a business so as to survive without relying on other people’s money. For MailChimp, learning to make money instead of spending it were just the essentials to keep their business running.
Understanding A Small Business is the Key

Although, MailChimp was approached by many potential investors from time to time, but Chestnut says that every time they had rendezvoused with investors, they failed to understand the gist of small business. They wanted to see the company at an enterprise level with a large number of employees
Chestnut further said that they were often told that they were sitting on a gold mine, but something about this idea never felt right to them. For the founders of MailChimp, it was all about proving to small businesses that they can do it just like Chestnut and Kurzius made it happen. Being a small business itself, this mail service company could understand the requirements of other small businesses fairly well. Despite the high level of uncertainty that persists in the tech-world, both of them feel that the company will run better if they control it rather than the outside investor.

Therefore, a startup doesn’t always have to let venture capitalists control them by fueling their ideas with a large amount of debt. Instead, they can be the pirate of their own ship and sail it through highs and lows the way they desire.