The Incredible Shrinking Seed Stage and Other Venture Trends of 2014

Opinion

By now the 2014 data for venture capital investments from the most important regions of the world have been compiled and disseminated. When laid out next to each other, some fascinating themes emerge.

It’s no surprise that the U.S. continues to set the pace with over $48 billion invested in 4,356 companies, compared to 2013, when nearly $30 billion went into in 4,193 companies, according the National Venture Capital Association’s MoneyTree Report. Overall, the average size per deal increased from $7.1 million to $11.1 million in 2014.

But when one looks closer, the rotation from seed and early stage deals to expansion stage investments was quite dramatic—41 percent of all capital invested in 2014 was in expansion stage companies, as compared to 33 percent in 2013. The average round size of expansion stage investments spiked to $17 million from $9.5 million in 2013.

This underscores a significant development in the venture capital market—companies are raising larger later stage rounds and staying private longer.

Arguably, venture investors are generating greater overall returns by encouraging portfolio companies to stay private longer. In 1986 Microsoft went public at a $500 million valuation and traded to over $3 billion within the first year (and then increased 30-fold over the next 8 years). Google went public in 2004 at a roughly $25 billion valuation and traded to over $80 billion after its first year. Facebook went public in 2012 at a $100 billion valuation and, after some hits to its stock price, recovered its IPO valuation nearly 15 months later. And of course, Alibaba went public at a $225 billion valuation and now trades slightly lower, with a market cap of about $210 billion. These are only a few of the most notable success stories, but they demonstrate a company’s ability today to raise very large private rounds of capital to fund hyper-growth, affording early stage investors much more of the upside.

Against this backdrop, though, there is an explosion in the number of early stage companies being formed, and many of them are not raising traditional venture capital.

In 2014, over $718 million was invested in 192 seed stage companies by venture firms. That compares with more than $1 billion that VCs invested in 235 seed stage companies in 2013. Crunchbase had over 25,000 companies in its database in 2008; today that number is converging on 700,000, and a very small percentage of them raised capital from VCs. With fewer active venture capital firms nowadays, one might argue that the VC industry may not be well-positioned to provide seed capital. Maybe VCs are not able to compete as effectively against other sources of capital, such as incubators and super angels? Or maybe VCs are simply being more discerning, given the lack of differentiation between so many look-alike startups?

Shikhar Ghosh, a Harvard Business School senior lecturer, recently studied 13,500 venture-backed companies to see how many failed to return 100 percent of their capital to first-round investors, and the results are disturbing.

Since 1990, 76 percent of the companies in this study failed to return 1x to first-round investors (82 percent in the 1996-2000 vintage were particularly guilty of that). Even more troublesome (although perhaps not that surprising), in cases when the founder was fired, 90 percent of the companies failed to return all the capital invested by first-round investors. According to Pitchbook, 40 percent of all VC-backed exits in 2014 amounted to more than $100 million, which means one of two things (or both): Most of those returns went to later stage investors, or the capital loss rates for the other 60 percent of those exits in 2014 must be very high. In other words, many of those companies sold for much less than invested capital.

Here are some other notable trends that emerged in the 2014 data:

—Healthcare (biotech, medtech, and services) killed it last year, having raised in aggregate over $9 billion (or 19 percent of total dollars raised). That contrasts to the $6.9 billion the healthcare sector raised in 2013, and clearly reflects the extraordinary investor liquidity in biotech. Average round size for healthcare was $16.5 million.

—Software companies (including Web startups) raised $19.8 billion, or 41 percent of all dollars invested in 2014.

—Media and entertainment deals more than held their own, raising $5.7 billion across 481 companies for an average round size of $12 million.

—Telecommunications came in last place of the 17 categories tracked, with only $324 million invested in 43 lonely companies.

—Nearly $7.4 billion was invested in first-time financings, or 15 percent of all dollars invested; 40 percent of the $7.4 billion was invested in software companies, mirroring the broader investment activity.

—While innovation is a global phenomenon, Silicon Valley just killed it again in 2014, accounting for $23.4 billion (or 49 percent of the nationwide total) across 1,409 companies (32 percent of the total). Interestingly, round sizes were meaningfully larger for Valley-based companies—$16.5 million versus around $11 million for New England and NYC Metro-based companies.

—New England and NYC Metro were both a distant No. 2, with each region accounting for a total of $5 billion in venture funding. Including Silicon Valley, the top three regions accounted for nearly 70 percent of all investment activity.

—Twenty states had fewer than 3 investments in the fourth quarter of 2014, and 10 of those had no venture investments at all, which amazes me.

Another exciting geography is obviously China, which showed dramatic growth, with $15.5 billion invested in 2014—or twice the previous record set in 2011, according to VentureSource, but still about one-third of the U.S. level.

In the fourth quarter alone, China invested over $6.8 billion in 243 companies. Much of the investment activity was focused on consumer-centric businesses. IPO activity on local exchanges recently returned as Chinese regulators spent nearly a year overhauling the process to take companies public to provide greater transparency for investors. There were 61 IPOs in China in 2014, with a total value of $7.2 billion. While that’s down from the 141 IPOs in 2010, it was meaningfully greater than the 15 IPOs in 2013. Clearly the “Alibaba halo” still shines bright, and there’s more to come. Chinese venture capital firms raised $4.2 billion in 2014, while U.S. private equity firms raised $47 billion.

Investment activity in Europe was also robust—$8.9 billion (or 7.9 billion euros) was invested across 1,460 companies in the Continent (average round size ~$6 million as compared to $11 million in the U.S.). Arguably, this activity was also tied to strong IPO activity, as there were 55 IPOs in Europe that raised 3.7 billion euros (compared to 2013, when 18 IPOs raised 500 million euros).

As in the states, Europe has seen innovative new funding models develop, such as “equity crowdfunding” platforms that take equity in the startups. However, the U.K. Financial Conduct Authority recently raised significant concerns when it noted that 62 percent of the investors on U.K. crowdfunding websites had no prior investment experience! The British regulators also estimated that $127 million was raised on these sites last year.

Michael Greeley is a General Partner at Flare Capital Partners, a healthcare technology venture firm. Follow @greels1

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