When Startups Turn Down

Editors’ Note: MarketMinder doesn’t make individual security recommendations. The below merely represent a broader theme we wish to highlight.

Once upon time, apple pie and baseball were supposedly the biggest American hallmarks. But these days a challenger has seemingly usurped them: the obligatory congressional testimony from the head of every financial company that implodes. So it went today, with former Silicon Valley Bank (SVB) CEO Gregory W. Becker testifying to the Senate Banking Committee on the bank’s risk management practices and his opinion of why it failed. Most coverage honed in on his assertion that Fed rate hikes bear the blame, but we found a far more interesting rabbit hole in his prepared remarks: When you marry the eye-popping growth in SVB’s business deposits in 2020 – 2021 with a Wall Street Journal report on venture capital funds’ sweeping writedowns Tuesday, you get a pretty good look at how the market is squeezing the froth out of Silicon Valley—and a very timely reminder that start-ups aren’t one-way investments.

Ever since the Tech boom started in the 1980s, there has been a big public fascination with startups and Initial Public Offerings (IPOs). Apple. Microsoft. Dell. Netscape. Google. Facebook. Even when booming companies busted in equally spectacular fashion, onlookers dreamt of getting in on that initial jump and then selling at the exact right time. Startups often lure workers with generous stock compensation packages, offering visions of a huge windfall that will land them a Bay Area house when they inevitably conduct an IPO or get bought by a larger competitor at a huge premium. As headlines hyped success stories and press releases glowed about every company that got new funding at a huge valuation, it cemented the perception that startups go one way and one way only.

Myths like this tend to attract money. A lot of it. A massive wave poured in during COVID lockdowns and their aftermath. While some basic COVID winners in Tech and Tech-like industries saw returns, profits and valuations jump, speculation also kicked in. The boom in Special Purpose Acquisition Companies (SPACs)—holding companies that go public with the express purpose of merging with a private startup—was another. But a lot of the froth was stealthier, building up in startups. They attracted money hand over fist, and so did their venture capital investors as institutions and high-net-worth folks sought to juice returns. Given startups had stayed private for longer and longer since Sarbanes-Oxley raised compliance costs for publicly traded companies in 2002, getting in on the action pre-IPO increasingly looked like the only way to capture big riches.

Froth is hard to measure, but SVB’s numbers give a pretty solid clue as to how much money chased startups in the COVID era. In his testimony, Becker reiterated that SVB’s deposit base was concentrated in technology and life sciences companies and described it as a place “where start-ups and later-stage companies could keep their deposits, borrow to expand their businesses, and create jobs.”^[i] From 2015 – 2019, he said SVB’s assets grew around 10% a year. In 2020, that growth rate ballooned to 63%. In 2021, it grew “another 83%.” Those are huuuuuuuuuuuuuuuuge figures that imply startups and later-stage pre-IPO Tech companies were attracting a wall of capital.

Becker’s testimony didn’t include a growth rate for 2022 … or, for that matter, any stats on how the bank’s deposits trended that year. We think there is a simple reason for this: 2022 is when the party ended. Around Silicon Valley, there were anecdotal reports of venture capital funds pulling back. Many startups that still received funding did so in “down rounds,” at a lower valuation. In publicly traded markets, Tech and Tech-like industries got hit hardest during the bear market as the prior years’ excess reversed.

Private companies didn’t immediately reflect the same hit, largely because their investors’ reporting requirements differ. Private equity and venture funds may report quarterly or annually, depending on the requirements where they are domiciled, but there is no set criteria for valuing their illiquid holdings, which enabled some to take their time when writing down the value of struggling startups.

When we wrote about this last December, we noted that the delay created the misperception that unlisted securities were somehow less volatile than their publicly traded counterparts—a dangerous myth. But as the Journal reported Tuesday, more are now paying the piper. “For the first time in more than a decade, returns for venture funds were negative for three consecutive quarters last year, according to research firm PitchBook Data, as investors finally began to mark down startups that had ballooned in value. Initial data for the fourth quarter also show a negative quarterly return. The data also show that the yearly internal rate of return hit minus 7% in the third quarter—the latest data available for that measure—the lowest value for those three months since 2009. The internal rate of return is used to measure the profitability of venture funds on an annual basis and is a key performance metric used by the industry.”^[ii] One fund has written down startup values by a third. Other funds and their limited partners see more pain ahead, with more writedowns and tighter liquidity. Higher long rates have torpedoed the old model of using cheap leverage to juice returns and startup valuations. Fundraising is down. Without a flood of new money coming in, startups will have to make it on their own, and many will probably fail.

From a cold and rational perspective, this is a good thing for the Tech world and US economy’s long-term health. When companies that lack a viable long-term business model are allowed to fail, it cleans the slate (and frees up funding) for newer competitors to take their place. This “creative destruction” is a driving force of capitalism and long-term development, and it creates returns and rewards risk-taking in the long run. That propels economies forward and makes everyone better off. Economies that can’t go through this process stay bloated and uncompetitive, which usually means slower growth and weaker returns (see: Japan).

But also, it is a very important reminder: Startups go down as well as up. Investing in them isn’t a free windfall, nor is private equity somehow an isolated asset class from public equity. Hard as it may be to fathom, the valuations that get attached to funding announcements are just one group’s estimate of the company’s value. In reality, as long as a company is confined to private markets, the only valuation that matters is the last one—the one on the IPO date, the one an acquiring company pays, or the goose egg that accountants pencil in when the company fails. That last one happens often; it just doesn’t get publicized because it isn’t a fun story.

In our view, this is what those rushing into startups during lockdown missed. It was a classic hunt for the next big winner, the behavioral error of trying to buy a repeat of past returns. That may work, very occasionally, if you pick the right needle in a very big haystack. More likely, you will pay through the nose to participate in venture funds whose holdings are diluted and illiquid, and you will quickly find that between redemption gates and early withdrawal penalties your personal returns are nowhere close to what you envisioned.

Now, compare that to publicly traded stocks. They are liquid, so you can know at any time what your holdings are worth. They are easy to access—you don’t need to go through intermediaries that charge several percentage points for the privilege. In many cases, commissions are zero or close to it. If and when you need to sell, you can do so with reasonable expectations that you will get the most recently quoted price—and that a buyer will be ready to step in. Best of all, while the broad market may have a less exciting return than cherry-picked startup successes, stocks’ roughly 10% average historical annualized return can compound to very large absolute returns over a long enough time horizon. That isn’t quick riches, but that isn’t what investing is about. It is about discipline, patience and a journey to long-term returns.