The general status quo of the venture capital market: competition is fierce and returns are concentrated in specific areas

Author: DEZ

Compiled by: Deep Wave TechFlow

What is the current situation of the venture capital industry? If you ask a VC what they think of the current market, you'll likely hear three consistent statements:

A) The market is too crowded

B) Competition is extremely fierce

C) The rewards are concentrated at the top.

This is an interesting and consistent comment, especially given the critical role that venture capitalists play in the startup ecosystem. So, is venture capital a dying asset class? of course not. But does it face structural challenges? no doubt.

Let’s explore the reasons from a macro perspective.

Three high-profile venture capital-backed companies have gone public as of 2024: Reddit, Rubrik, and Ibotta. As of earlier this week, the three companies had enterprise values ​​of approximately $10 billion, $6 billion, and $2 billion, respectively, and expected to achieve $1.2 billion, $922 million, and $415 million over the next twelve months. income.

These companies are large, well-capitalized, and well-known businesses with thousands to millions of loyal users. These companies have crossed the so-called "chasm" and are striving to become efficiently run public companies. These multi-billion dollar success stories are a venture capitalist’s dream and can dramatically enhance our careers.

However, while returning capital is the only thing that matters to VCs in the long run, we (as an industry) are still very willing to suspend disbelief when it comes to a core part of what we do – pricing.

Over the past few weeks, the early-stage startup landscape has continued to bifurcate into two types: AI-native companies and everything else.

AI native companies focus on application, inference and cutting edge/deep technology model layers. Companies like Hebbia recently raised funding at a $700 million valuation, Cognition Labs is now valued at $2 billion (just 6 months later, pretty staggering), and Harvey is reportedly close to completing a funding round at a $1.5 billion valuation.

The truth is, we don’t live in a financing environment where these valuations are few and far between. In fact, they are quite common. Other companies such as Glean (valued at $2 billion), Skild AI (valued at $1.5 billion) and Applied Intuition (valued at $6 billion) are also reinforcing this trend. I know three companies in particular, Hebbia, Cognition, and Harvey, and they have several advantages:

1. They are making money: Hebbia is reported to be profitable at $13 million in revenue, and Cognition is probably in the 5 million range to $10 million, with Harvey earning more than $20 million.

2. They are building a brand and talent density for themselves: If you look at their workforce makeup, there are a lot of Ivy League graduates and tech veterans.

3. They have well-known brand clients: such as PricewaterhouseCoopers, KKR (Kohlberg Kravis Roberts & Co.), T-Mobile, Bridgewater Associates, US Air Force, Centerview Partners, etc.

4. They represent another generation of application software: focusing more on work results rather than workflow (i.e. don’t do my work for me, do it for me directly).

However, despite questionable unicorn valuations, they are all firmly in the “chasm”. There is no guarantee that they will survive the day they are launched. Competition in this field is fierce. The technology they build may plateau and fail to provide a clear enough return on investment for their end customers. Moreover, public company peers are 20 times larger in revenue scale, have clearly established themselves as market leaders, and are valued at 5 to 8 times next 12 month revenue, rather than 20 to 100 times future revenue. Valuation.

This is the structural challenge facing the venture capital industry: an excess of capital but few high-quality assets to invest in, which leads to unsustainable valuation increases and ultimately undermines equity value. However, some of these crazy valuations will appear relatively cheap in hindsight. There are indeed some real, lasting, generation-spanning companies being built today, it’s just that no one can clearly tell which companies will become Webvan and which will become Doordash.

(Translator's Note: It is difficult to predict which companies will eventually fail and which companies will be huge successes.

Webvan: An online grocery delivery company founded in 1999, but due to poor management and market demand Due to underestimation and other reasons, Webvan eventually went bankrupt in 2001.

Doordash: An online food delivery platform that was founded in 2013 and expanded rapidly, finally successfully going public in 2020. Becoming a multi-billion dollar company. Doordash is the poster child for entrepreneurial success )

Companies like Doordash generate great returns for their investors, which in turn inspires investment in venture capital as an asset. A new wave of interest in the category. This cycle keeps repeating, and by 2040 we may be talking about a new investment technique that suffers from similar price dislocations. This is the current state of venture capital. To further illustrate this point, there are a few themes that I think are very clear regarding the current state of venture capital:

1. We are in a period of low liquidity, near the bottom of the market cycle. 2022 has been the year with the fewest IPOs since the global financial crisis, and 2023 will not improve significantly.

2. Apps have been the gift that keeps on giving, accounting for 8% of all IPOs since 1996, but it is maturing as a venture capital sub-sector. As a result, the investable market opportunities are shrinking.

3. Venture capital has never been more competitive. The venture capital asset class has more than quadrupled in the past 20 years. This reflects "your profit margin is my opportunity."

4. For assets that are considered unique, price is no longer a consideration. Revenue multiples of 100x are accepted and increasingly common.

If I had to simplify my core argument, it would be that when you turn $7 million into $4 billion, it tends to attract competition, and competition is the defining factor in the current state of venture capital. Pricing, deal velocity, the intensity of the deal process, all of these are born out of competition, and the competitive dynamics in the venture capital space today are on full display with A Tale of Two Cities; there are AI-native companies and all the rest right now.

Now the real question is, if this is the current state of venture capital, so what? I have my own ideas and strategies that I'm implementing, but I'll keep those ideas to myself for now. In the meantime, I wish you all a great week and good luck with your investing.

1. For the avoidance of doubt, I have not spoken directly with these companies. These figures are estimates I gleaned from public records and private conversations.

2. To be clear, I’m not saying these are prerequisites for success, but they are strong early indicators of the density of talent being gathered.

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