History rhymes rather than repeats

There are sometimes seminal moments to capture the zeitgeist. One that could be about to happen is when venture capital-backed companies account for half of total US stockmarket capitalisation.

Already, venture-backed companies account for 41% of market cap and, given they are responsible for 62% of US public companies’ research and development (R&D) spending and a surge in flotations in the past year through the special purpose acquisition company mania to buy corporate venture-backed startups (see analysis), it seems only a matter of time until they cross the 50% threshold.

The six largest US companies (Apple, Microsoft, Alphabet (Google), Amazon, Facebook and Tesla) by market capitalisation at the end of last year received most of their early external financing from venture capitalists.

They collectively have contributed over $7 trillion to the US stock market over the past decade and accounted for more than one-quarter of the US stock market growth over that period, according to academics Will Gornall and Ilya Strebulaev at University of British Columbia and Stanford University, respectively, in their paper, The Economic Impact of Venture Capital: Evidence from Public Companies.

Among public companies founded within the past 50 years, 
VC-backed companies account for half in number, three quarters by value, and more than 92% of R&D spending and patent value, the academics added.

Strebulaev said while the creation and growth of companies was generally lumpy, because of macroeconomic trends and fluctuations (and in the long-term because of impact of other forces such as wars), “the VC industry adds a large layer of creative activity on top of this lumpiness”.

The US did not spawn top public companies at a higher rate than other large, developed countries prior to Employee Retirement Income Security Act of 1974 and its reforms that decade to allow commitments to venture capital (VC) funds, but produced twice as many after it. Using those reforms as a natural experiment, the academics suggests “the US VC industry is causally responsible for the rise of one-fifth of the current largest 300 US public companies and that three-quarters of the largest US VC-backed companies would not have existed or achieved their current scale without an active VC industry”.

The blurring of public and private capital markets in terms of liquidity, flow between them and potentially governance is seminal.

The Economist recently highlighted an interesting paper by Xavier Gabaix and Ralph Koijen, of Harvard and the University of Chicago respectively, about how flows of money move stock prices.

This has always been pretty self-evident in the private markets but less so for public markets.

The standard picture for share prices, as the Financial Times noted last month, is one in which stock prices reflect only information (or at least beliefs) about fundamental value, ie some version of future cash flows, rather than supply and demand, that is – flows.

The standard model was developed during a period of relatively high retail shareholdings – the era of so-called people’s capitalism – but since the 1980s the rise of market capitalisation of the main indices reflects institutional investors.

These big buyers are often the pension funds, life assurers, banks and mutual or exchange-traded funds working under strict mandates governing their portfolio mix. When an investor gives such a fund a fresh $1 to invest in stocks (“money going in”), the fund must put it to work according to its mandate, the FT notes. When a retail shareholder invests through Robinhood in a stock it is more discretionary based on the price or alternatives available, such as going out to a restaurant or having a meme to talk about to friends online through covid-19 lockdown.

By contrast, the flow of money going in or out of VC relatively has clearly always impacted valuations.

During the first golden age of VC investing – the silicon and software era from 1980 to 1997 – VCs posted average quarterly returns of 22% as there was relatively little money around immediately after the change in pension fund regulations at the start of that period.

Research by University of Chicago economists Steve Kaplan and Antoinette Scholar found that VC funds outperformed the S&P 500 on a capital-weighted basis over the same time period.

But the Netscape flotation in 1994 and subsequent boom in initial public offerings (IPOs) for loss-making startups quickly saw a 250% increase in VC-backed deals between 1997 and 2000 and a quintupling of investment dollars as limited partners flocked to commit to VC funds.

The dot-com implosion after the millennium meant few exits and hence less interest in backing VC funds to do new deals.

From 17 IPOs per week in the US in 2000 this dwindled to 15 IPOs in 2008 and 2009 combined while the total number and value of investments in 2009 (2,800 deals raising an aggregate $17bn) was less than the year-2000 peak of nearly 8,000 deals raising $100bn, according to Thomson Reuters.

The past decade, of course, has seen this momentum swing back to abundance led by strategic investors initially and increasingly by institutional investors directly backing startups rather than indirectly through VC funds.

The second quarter of 2021 seems to be just another page in this bullish story, with virtually every metric tracked by GCV Analytics reaching a record high.

The number of rounds was 49% higher than in Q2 2020, with capital up 161%.

GCV Analytics tracked 1,263 funding rounds involving corporate venturers during the second quarter of this year, a 49% surge above the 846 rounds recorded in Q2 2020. The estimated total investment dollars stood at $75.04bn, up nearly 161% from the $28.69bn recorded during the same period last year.

Comparing Q2 2021 with the previous quarter, there was a significant increase in the deal count, going up 23% from the 1,025 in Q1 this year. Estimated total investment also went up by 32% from $56.74bn.

This meant the first half of the year registered a total of 2,288 deals with an estimated total capital deployed of $131.78bn, which is more by value than the peak 12 months for venture in the year 2000.

If the flow of money signifies signals a return to the dot com bubble era of rising valuations then a crash could follow when fundamentals reassert themselves.

According to The Economist’s calculations, those startups that have floated in 2021 made a cumulative loss of $25bn in their latest financial year.

Comparing the cumulative losses over time of selected startups that did float found many of these startups have huge valuations even as often their losses are growing, according to Wolf Street. Other than Pinterest, none of the startups in this chart suggest they are close to a turnaround in cumulative losses, analyst Jeffrey Funk said.

Negative earnings will sap even the most ardent spirits over time.

The froth has this summer already come off the special purpose acquisition companies that listed in search of the more speculative, venture-backed startups to buy.

But history tends to rhyme rather than repeat.

The ultimate flow of capital underpinning private capital markets comes from their blurring with public markets. The drag from lack of liquidity and higher bid-ask spreads in secondaries markets shows the clear improvements that can come from greater transparency and efficiency of allocating capital and resources to those who can use it best – whether in public or private hands.

If this continues as expected through decentralised finance and other initiatives then the level of deal and fundraising activity could be expected to remain high.

And it is clear the innovation trends and patterns that drew in the strategic investors from 2010 onward are still there. Whether in healthcare, financial services, energy, commerce, industry, communication and media or any other sector the waves of disruption are bigger and coming perhaps faster than ever before.

To take one example, electric vehicle maker Tesla sales are on par with early Ford Model T sales, according to Sam Korus’s analysis.

And Tesla is more than a maker of cars. Tesla is making impressive progress in artificial intelligence with a cost advantage that is nearly an order magnitude better than peers, according to semiconductor analyst, Dylan Patel.

“From core research to chips to the company’s ability to handle training data, Tesla is stepping ahead of the competition, and demonstrating the power of its increasingly integrated model,” according to Azeem Azhar’s Exponential View blog.

The power of innovation comes less from a good idea or business model but developing multiple ideas across multiple sectors. And here corporate venturing is the nexus to drive mergers and acquisitions, research and development and innovation by tracking multiple sectors for threats and opportunities.

The key is to remain committed and avoid the swings into and away from the industry. Moving earlier or later stage or into or away from countries or sectors as values dictate is understandable and reflects strategy as much as tactical awareness. But the hard work remains building a skilled team able to source, manage and exit deals and landing the value created back into the parent as well as the entrepreneur’s hands.

Consistently achieving this is hard but as we emerge from the summer months the tools to network, learn and share are coming back onstream so we at Global Corporate Venturing look forward to seeing you at the GCVI Summit and our other in-real life and hybrid events, helping your professional development and benchmarking through the GCV Institute and keeping you up-to-date and with the resources to advance the industry through our reports, publications, analytics and GCV Connect powered by Proseeder platform.

As ever, let us know how we can help your work making the world a better place through the efficient allocation of capital to those who can use it best and do fill in our annual survey.