Q2 2018 Quarterly VC Update: Stephen Kraus on the State of Venture Capital Investing

In conjunction with our Q2 Venture Financing Report, I sat down with Stephen Kraus from Bessemer Venture Partners to get his take on the state of venture capital investing.

A few highlights from Stephen Kraus

On deal terms: Generally, the terms have been company and entrepreneur favorable for a long time now, and they continue to remain that way.

On the proliferation of late-stage investors: It’s created this downward movement on stage of financing, and therefore upward pressure on what a normal Seed or Series A round looks like.

On Bessemer’s response to the influx of capital: We’re doing a lot more earlier-stage investing. The key to moving earlier is to know when to double down on your winners.

On fewer IPOs: There’s a lot more talk about companies staying private, and I don’t necessarily think that’s a bad thing … by definition if you have more time to mature, you should be more predictable and stable in your growth profile and earnings potential, which is generally more attractive to public market investors over the long term.

The key takeaway from our data is that the number of deals and amounts being raised are just going through the roof – which is interesting given that we all have thought that the threshold couldn’t get any higher than it has been over the past few years. We’d love to hear your thoughts on this macro environment. Does your experience match our data or is it inconsistent with what you’re seeing in the market?

I am not surprised by the data. It feels like we’re at “peak froth” in the market, which I don’t necessarily see changing, simply because I think venture capital, in some ways, has a lot of latency in the market, and what I mean by this is that obviously, the broader public equity and financial markets, as well as the broader economy are all performing pretty well. During times like this, I think you tend to see venture capital firms use the peak nature of the market to raise more and larger funds, and that has definitely been happening. General partners are raising larger funds and deploying those funds in shorter cycles and shorter fund lives. Where funds used to raise every four years, you now see funds going out to raise every two years.

There’s also a perfect storm of capital to continue to chase, with more companies being formed and a lot more capital chasing high-quality entrepreneurs. You see this in the data – valuations, especially for the mature companies that are performing well, continue to rise. And as the valuations rise, the round sizes rise. It’s definitely a frothy time out there.

It seems like entrepreneurship, specifically entrepreneurship in the high-growth space and venture capital-backed entrepreneurship, is having a bit of a social moment now, as exemplified by TV shows like HBO’s “Silicon Valley.” I remember when I was going through school everyone wanted to be a banker, and now everybody wants to be a startup entrepreneur.Do you feel like that is driving this cycle? Could it be that there is so much capital chasing these opportunities that this is becoming a more viable plan for folks? Do you have any other thoughts on the macro societal trends there?

I think there’s certainly a macro trend in in our society where you’ve got a “rise above” millennial generation that doesn’t adhere to the standard life/career/business mores. The concept where you first need to go get a job where you learn skills and then you advance up the corporate ladder – that’s all gone. I think the idea of being able to work for yourself as an entrepreneur is becoming more and more appealing. This is a generation who grew up with technology in every aspect of their life – they’re mobile native, technology native. So, it’s not surprising that you have more people wanting to chase entrepreneurship.

I do agree with the capital chasing theory, by the way – I went to Harvard Business School and I always say that whatever the graduating HBS class wants to do, you should just short that market. When I graduated in 2008, it was real estate. Well, it turned out that was a bad industry going in at that time, but now, I think you see the majority of HBS class graduates wanting to be entrepreneurs. This is partly driven by the type of graduate that’s entering the market, undergrad or graduate school, paired with it being a great time to be an entrepreneur. It’s relatively easy to raise capital now as compared to the market 10 years ago. So there are two factors – the broader societal factor and the market constraints, or lack thereof, in terms of capital chasing.

How are you feeling about deal terms? Are the terms more company favorable in light of increased capital chasing investment opportunities?

I think deal terms have been company favorable for five to seven years now, and I haven’t seen any change. When I looked through your data, the most interesting change I saw was an uptick in pay-to-plays, and I’m deducing you’ve got crazy, high-priced rounds for relatively early stage companies, and that you get a lot of late-stage capital flooding into the early stage market. So, if you’re going to pay a high price, put a lot of capital in and prop up the ownership of the early stage investors by definition, then maybe the way to give yourself some sense of protection is to have a form of pay-to-play provision. That said, I actually haven’t seen a lot of pay-to-plays in my deals. Generally, the terms have been company and entrepreneur favorable for a long time now, and they continue to remain that way.

The only other phenomenon that I’ve noticed shining through in your data is valuations increasing. Yes, on the later-stage deals, but even on the earlier-stage deals. I think it has a lot to do with the fact that there’s a lot of capital in the market – it’s an entrepreneur-favorable market, and valuations tend to creep up.

Obviously, there’s been the “SoftBank effect,” but they’re a unique case unto themselves. I’ve also seen private equity firms such as the General Atlantic, Carlyle, Warburg and Summit Partners of the world – those who tended to do buyouts or later-stage growth investing – starting to move even earlier, which for them means doing a Series C or D-type round. However, investing in highly unprofitable companies in those rounds has not been their modus operandi in the past. This means there are PE groups coming into these C and D-type rounds – a trend that’s causing the folks that used to do C and D-type rounds, like the IVP’s or the TCV’s of the world, to move into the Series B rounds, the investors that used to do the B-type rounds to move into the Series A rounds, and the A guys to move to Seed. It’s a downward movement on stage of financing, and therefore upward pressure on what a normal Series Seed or Series A round looks like. You see that in your data, and I absolutely see that in the market place more than anything else – it’s like, holy cow, those guys used to do buyouts, now they’re looking at my highly unprofitable software company. This is the strangest stance going on, and I think it’s happening in these markets because of the chase – people are looking for “value” anywhere they can find it.

How does that trend impact your thoughts on how to attack the market as an investor?

We move earlier. Bessemer has the ability to invest across stages – anywhere from $100 thousand to $100 million check size, we’re able to write. But, we’re doing a lot more earlier-stage investing. So we tend to move earlier in times like these.

You guys just kicked off a specialized seed-stage fund. Is this a reaction to that phenomenon?

In some ways, yes. For example, we’ve got this healthcare artificial intelligence/machine learning seed fund and, even for those companies, it’s still very early days in terms of those technologies being applied to healthcare. I think we’ve seen maybe 200 companies that serve broadly in that space and that maybe five are over $5 million in revenue. So, the majority are either total startup or sub a few hundred thousand dollars of revenue. And the ones that actually do have a little bit of traction in that space, say north of $1 million dollars, they’re raising really large Series A or Series B rounds, but they’re still very early in their maturity curve. We thus found ourselves getting priced out of those rounds. Given that it’s a relatively early market, our strategy is to make a bunch of seed investments across a number of great entrepreneurs and technologies and then follow those companies over time. This strategy is a reaction to what we are seeing in the market, for sure.

Is that affecting what you expect on returns, or is that still the same blueprint?

I wouldn’t speak for Bessemer here, but I generally think this vintage of venture is going to be a challenge as a whole asset class in terms of the overall return on invested capital. By definition, it kind of has to be… it’s just math – more money chasing after the relatively same number of deals at a higher price. That equation should mean lower returns for the overall vintage and asset class.

For us, we moved earlier, for sure, but when you look at our historical performance, early stage deals are where we get the outlier skew effect that drives venture capital funds. The key to moving earlier is to know when to double-down on your winners and decipher where there’s a signal that a company’s actually got breakaway growth or breakaway product market fit. And then, for those companies where you have an early stage position, really double-down on those winners – that’s the key to the model. With a big fund, we need to be able to do this. We’ve shown the ability to do this with some of our best companies like Shopify, Twilio, Yelp and Pinterest, where we did the Series A but then we invested significantly in the follow-up rounds, and I think that that’s the important part about making that model work.

Do you have any predictions on exits – either on IPOs or M&A? Given how much is invested in the early stage, what’s your sense of how those are doing and implications for trends going forward?

I would say the word “bubble” is thrown around. I said “peak froth” earlier, but the truth of the matter is that it’s a different sort of bubble than the 2000s bubble. I think the glass half-full scenario is that these companies are raising unicorn-type rounds and getting hundreds of millions of invested capital from SoftBank and other later-stage investors of the world. While those private equity firms may be moving earlier, these companies are still real companies. They’ve got real products that meet a real customer need. They’ve got real unit economics that work. They’re scaling quickly, and many of them have software-like margins so that, even if you stop investing in the growth and start focusing on profitability, you can get these companies into profitability in a relatively short period of time because the underlying gross margins are attractive.

So, essentially, what these late-stage investors are allowing these companies to do is take a longer time to develop before they hit the public market, and you see that in the data. There are just by far fewer IPOs. There’s a lot more talk about companies staying private, and I don’t necessarily think that’s a bad thing because, by definition, if you have more time to mature, you should be more predictable and stable in your growth profile and earnings potential, which is generally more attractive to public market investors over the long term.

Sure, you can hit an IPO window and have a nice pop and good first-quarter earnings, but the truth is that any experienced CEO who has been in the public market before will tell you it’s not about the first quarter, it’s not even about the IPO price, it’s about the eight quarters after you go public. I think these companies that are staying private longer should allow for more predictable companies to enter into the public market. That’s the positive side.

The negative side is obviously that there’s less liquidity. At least in the IPO sense, there’s less than I think some people would have hoped in the near-to-short term. At Bessemer, we have had a number of really special IPOs and a bunch of M&A, so we’ve been able to yield attractive returns, but I think in the broader market, you’ve obviously seen stories written and concerns about whether these companies are staying private too long.

I don’t worry too much about that because, to put it in another way, there have been a lot of unicorns and if I could buy the entire basket of unicorns out there, I would. Not every single one will be a winner, and yes, there will be some colossal wipeouts, but as a basket of companies, they are a really good set of private companies and I’d love to be a shareholder in an index of unicorns. I think that index is going to do well. The question is, what’s the timeframe? Is it the next couple of years? Is it the next five years or 10 years? It’s going to be a good basket of companies once they enter the public market.

Given that healthcare’s universe of buyers is a little bit more limited, and liquidity via the capital markets is a much more tried-and-true path, do you find any split between healthcare and tech in your outlook?

The biotech IPO market has been on fire for five years now. Frankly, strategic M&A in biotech has been the second-class option for exits because the public markets have been so liquid for biotech companies. Ten years ago, strategic M&A used to be your #1 exit option for biotech, and now it’s definitely IPO.

I don’t think the buyer universe is actually that small. There are a number of healthy and strong-balance-sheet pharma and biotech, large and medium sized, that could be buyers. I just think they’re currently having a hard time competing against the public markets.

And, for the companies that are still earlier in the growth phase (because they’re in pre-clinical or early clinical development), they want to be able to access public markets to help push for the development of their products – versus selling now at what would presumably be a discount given that there are clinical and regulatory risks. I think most biotech entrepreneurs would rather access the public markets and have the capital to play out the experiment, if you will.

And in your area of focus on technology in the healthcare space – are you seeing more of the traditional Silicon Valley-style tech exit?

Yes, there’s been a lot of capital poured in the healthcare IT and services space. While still not as robust as the biotech market, there have been some strong IPOs like Teladoc and Evolent Health. I think the M&A universe is pretty large there, though, and so you’ve seen, for example, Flatiron Health exit to Roche, PillPack exit to Amazon and Optum and United Healthcare be very strategically active. You’ve got a whole set of payers and a whole set of traditional healthcare IT companies. With some of the traditional tech companies like Amazon, Google and Apple getting into the space, I think there is a large set of strategic buyers in that universe. 

About Stephen Kraus

Stephen Kraus is partner at Bessemer Venture Partners and leads the firm’s healthcare investing activities. He currently sits on the boards of Welltok, Bright Health, Groups, Qventus, Health Essentials, Docent Health, Alcresta and TScan, and is a board observer at Collective Medical Technologies. Steve has been recognized by Forbes Magazine as one of the top healthcare investors in the industry. He co-hosts the podcast “A Healthy Dose” and often blogs about his views on the healthcare industry.

About Bessemer Venture Partners

Bessemer Venture Partners (BVP) is a $4.5B global venture capital firm that invests in consumer, enterprise and healthcare startups from seven offices around the world. One of the longest standing venture capital firms in the world, Bessemer invested in the early stages of Pinterest, Twitch, Bright Health and Skype and has helped 122 of its companies go public, including SendGrid, Twilio, MindBody, Shopify, Wix, Yelp and LinkedIn.