In conjunction with our Q2 2023 Venture Financing Report, I sat down with Steve Harrick of Institutional Venture Partners (IVP) to get his take on the state of venture capital investing.
Key insights from Steve Harrick
On public financing in Q3 and Q4 2023: “There is still a lot of capital available that has been raised by venture funds, but it is a difficult deal environment when the last round prices were as high as they were in 2020 and 2021.”
On investor attitudes toward AI: “Our belief is that the value from artificial intelligence and machine learning will be enormous, but it will play out over the next several years.”
On investor reactions to market contraction: “What is different from some other cycles is – although the tourists have left, as they usually do when markets contract – the consistent venture practitioners raised a lot of money that will eventually need to find a home.”
Although we have begun to see a rebound in Q2 2023, global venture capital funding has fallen dramatically as compared to the go-go years of 2020 and 2021. Is that entirely attributable to the current state of capital markets for technology companies and, relatedly, to interest rates being higher than in recent history, or are there other factors at play?
I don’t view the uptick as statistically significant. In 2020 and 2021, interest rates were at record lows, and it was an environment where people were being very aggressive in terms of capital deployment. That resulted in more companies getting financed at higher valuations and larger round sizes, meaning companies were taking on more capital.
What happened subsequently is that the public markets corrected dramatically – multiples compressed. There’s been a significant recovery over the last few months in the Nasdaq and tech stocks, but multiples, compared to where they were in 2020 and 2021, are much lower. Tech companies are not going public, but those that raised a lot of capital still have capital left, so they are saying: “We’ve got $70 million on the balance sheet, our last valuation was at $2.5 billion, we’ve got $40 million or $50 million in revenue, and if we went out to market, we wouldn’t be able to reach our last ground valuation.”
But the boards are saying: “Lower costs, grow more efficiently, converge on profitability, and don’t go back to market right now.” Because they’re trying to avoid a down round.
Over time, those companies will need to be financed, and if they can’t do it publicly, they’ll need to do it privately, so I think you will see down rounds increase in terms of frequency.
There is still a lot of capital available that has been raised by venture funds, but it is a difficult deal environment when the last round prices were as high as they were.
Artificial intelligence is huge right now, and we know IVP is in the thick of it, investing in companies at the forefront of AI, such as DeepL, Jasper, Grammarly and Traceable. How have recent developments in AI continued to affect or shift your investment strategy, including outside of AI?
Machine learning (ML) has been going on since the end of World War II, and while this technology has been evolving for a long time, it has gotten increasingly sophisticated as processors become more powerful and cheaper. You can offload to the cloud, you can do neural networks, and you can write algorithms that take in vast data sets. The advent of ChatGPT was really a kind of “coming out” time for this technology.
I worked at Netscape in 1996, and it was the same for the internet back then. You put a browser on the front end of the internet and made available to everybody what had previously only been available to academics. ChatGPT is now doing the same thing for AI. Everybody can use it, play with it, understand it.
There’s a frenzy in AI and ML right now, but people really aren’t sure who the leaders will be. I think you are seeing some vertical applications like DeepL gets real traction. Traceable is using it for application programming interface (API) security. A lot of our portfolio companies were using AI before it became enormously popular, such as Grammarly and CrowdStrike.
And AI does affect our investment practice. As a matter of fact, we recently hired Tamar Yehoshua as a new venture partner. She was the chief product officer at Slack, and before that, she led AI and ML initiatives for leading multinational technology companies. She is now heading up our AI efforts, which will affect all of our investment activity. But I really believe the long-term value will take years to emerge.
Software is going to get smarter. It’s going to be able to make more real-time decisions and deliver more value to customers. But if you are a customer, and I come to you with a hot new AI application, you’re going to say, “Show me how it works, show me why it’s different. Show me why, with a future release of ChatGPT, this won’t just be free for everybody to use.” You’ll naturally be skeptical, and I’ll have to show you the business value. That will take one to two years in some areas, eight to 10 in others – but the tailwinds will be persistent.
Our belief is that the value of AI and ML will be enormous, but it will take years to play out. But the software landscape has already changed permanently.
What current VC trends excite you, and what trends cause you concern?
In terms of trends and the health of the VC industry, one of the things that excites me the most is a return to fundamental business building.
Resets and valuation downturns are painful. We’ve always been a cyclical business, and we always will be. In down cycles, the old rules that govern commerce come back into play – meaning that you don’t just buy growth at all costs. You invest intelligently, keep customers happy, grow revenue, amortize costs over a bigger base and become profitable.
In technology, the markets give you a lot of leeway, because you’re doing something new –you’re creating a new market. Investors don’t ask you to become profitable right away. But eventually, you must be. I think we will be able to run companies in a more responsible fashion than when you run them and say, “Whatever we spend, somebody will pay a higher price. So, let’s just keep spending.” That is what was happening in 2020 and 2021, and it’s happened in other bubbles. I witnessed it in 1999 and 2000.
In the short term, it’s going to be painful – hard on liquidity, more down rounds, more rationalization of business, more mergers & acquisitions – all of that will take place. But it is going to be better for the company’s long-term health.
Other technology trends that are big include security, which is a big focus of mine. I’ve backed CrowdStrike, Anomali and Traceable, among others. Cybersecurity is a never-ending battle between offense and defense, and we need to secure data and protect it.
Another is infrastructure, which is always changing. How do you use open source effectively in commercial applications? What is old and not meeting the needs of current customers? What infrastructure is going to support AI most effectively? That’s an area where we’re spending time.
What is the most common piece of business advice you give to companies you work with within the context of fundraising?
I really like to ask the “use of proceeds” question.
If you raise a new round of capital, let’s say it’s $30 million or $40 million, and you’re at a certain point in your business, I like to ask, “What will this additional capital do for you? How will you use it? What will this company look like before it raises its next round, either publicly or privately?”
That tests their command of the business, shows how they will use capital and clarifies what the business should look like before it raises again. And it gives the venture capitalist confidence that the next round will be north of the current price they’re paying.
If someone can’t answer these questions, and they don’t know what they’re going to look like, but they’re driving a high valuation, and they don’t have much revenue, that raises some flags for us. Because if they take your capital and use it inefficiently, then they’re going to come back to the market, and somebody’s going to say, “I can’t get to the price that IVP just paid.”
That’s the way venture capital has always been done responsibly. You raise capital, you invest it, you build your business and mitigate risk over time. By the time you go public, you can give guidance, and public investors can say, “OK, I understand, that’s a fair price. I’m going to buy into this company.”
And then you meet and exceed that guidance. That’s how you create value for everybody. Remember that with the best venture capital opportunities, all the investors make money all the way along.
VC financing started to rebound over the last quarter, as did the percentage of down rounds. Is this a fluke, or do you see further quarter-on-quarter increases on the horizon?
I think you’ll continue to see the number of deals increase – meaning that companies that raise those rounds are starting to exhaust them, and they’re going to need to raise money at some price.
I think you’re also going to see the number of down rounds increase. Companies may be low on cash, they’ll need new capital, the last price was too high, they made progress, but not enough to exceed the last round price. So, they’re going to raise money, but they’re going to have to take terms or a down round – or a flat round if they can pull it off. The really great companies will still be financed in an up-round valuation, and I think that will be the rationalization of the financings that took place in 2020 and 2021.
The difference between other cycles is that – although the tourists have left, as they always do when markets contract – the consistent venture practitioners raised a lot of money that will eventually need to find a home. They must find a way over time to put that capital to work so it’s not going to cause the complete collapse of valuations, but people are going to be very selective.
Are there any other observations on this quarter’s VC data worth noting, or do you have any other “gut feel” observations you can share?
Fast money comes and goes. Hedge fund money was fast money – limited due diligence, no help, high price, “don’t call us, talk to our consultants” – and not the best way to build businesses.
But venture capital is an amazing business. Firms like IVP have a lot of experience in pattern recognition. When we invest, we are hands-on. We help companies hire, plan, monitor and manage their business.
The best venture firms will build great, sustainable companies that will generate compelling returns long term. But if anyone thinks they’re going to be investing and flipping something for a profit right now, they’ll be disappointed.
From the outside, a lot of people think, “Oh, those venture capitalists, they just put money in and get rich right away.” It doesn’t work that way. You must do this business because you love it. And creating value takes time. That’s what I’m comforted by in down cycles. It’s a time to build.
About Steve Harrick
Steve Harrick is General Partner at IVP, where he works with technology companies offering exceptional growth potential, with a concentration on companies focused on enterprise infrastructure, applications and security.
After 25 years and several cycles, Steve continues to be energized by working with entrepreneurs breaking new ground and is excited to share what he has learned to further their success. Most often, Steve helps CEOs and management teams identify the areas in which improvement will drive the biggest impact – the specific functions that will truly bolster their business.
Steve was recognized as one of the top 100 venture capitalists in the world by his inclusion on Forbes’ Midas List and the AlwaysOn Top 100 VC list. He is a graduate of Yale University, where he also was an NCAA Division I wrestler, and he received an MBA from Harvard Business School.
About Institutional Venture Partners (IVP)
IVP helps breakout companies grow into enduring market leaders. With a 40-year record of supercharging growth and 130+ IPOs, IVP has partnered with over 400 companies including Coinbase, CrowdStrike, Datadog, DeepL, Discord, Dropbox, GitHub, Grammarly, HashiCorp, Jasper, Klarna, Pigment, Slack and Snap. As trusted allies, IVP helps founders and CEOs meet the challenge of leading a rapidly growing company.
[View source.]
