Venture capital’s delayed rendezvous with reality

The venture capital bubble is facing a slow and messy unwinding. After a historic boom that puts even the tech bubble of the 1990s into the shade, an adjustment to more rational conditions has started. But structural factors and the psychology of private markets make it hard to tell how long this will take — or what will emerge on the other side.

Two contrasting pieces of news this week make the point. One is the confirmation that Klarna has had to accept a radically lower valuation in order to raise fresh capital. The Swedish buy now, pay later company’s latest fundraising values it at $5.9bn before the injection of new cash, an 87 per cent slide.

The other is that there is more money than ever trying to crowd into the venture capital market. At the end of June, venture funds had a record $290bn on hand waiting to be invested, according to data from PitchBook. That is fully $100bn more than was burning a hole in their pocket as recently as 18 months ago.

Normally, you might expect a tidal wave of cash like this to buoy up valuations. But for companies such as Klarna, with a need for money in a hurry, the terms have suddenly become punishing. One result is that the number of mega fundraisings — the $100mn-plus rounds that characterised the boom — dropped nearly a third in the second quarter, according to CB Insights. Yet the number of fundraisings is still abnormally high on any historical comparison.

It will take time for reality to settle in. After a collapse in growth stock valuations in the public stock market, a rapid reset in the private world might seem inevitable. But there is almost no incentive for any of the participants to acknowledge that the good times are over. Quite the opposite, in fact.

For the founder of a successful start-up hitting its growth targets, particularly in the relatively early stages, bowing to Wall Street’s new view of reality seems like an act of self-flagellation, particularly since you are not even public. A down round — raising money at a lower valuation than the previous round — punishes the wallet by diluting existing investors and feels like an unjustified admission of failure.

Maintaining the fiction that nothing has changed carries other benefits. For one thing, it means you can keep issuing restricted stock and options to workers at the old valuation levels, as long as the employees are happy to go along with it.

Investors also have plenty of reasons to bury their heads in the sand. For years, many start-ups have seen upward-only revaluations from successive rounds of capital. The investment managers at the limited partners that provide VC firms with cash were able to show their own investment committees returns that were heading in only one direction (and collect healthy bonuses along the way). Why rock the boat now when there are no requirements to force a revaluation in the other direction?

The other big distortion that is preventing a quicker return to normality is the massive overhang of capital. How long this will take to unwind is hard to forecast. Even the $290bn held by venture funds does not catch the full picture, since the real glut of capital in recent years has come from beyond the traditional venture world.

Hedge funds, private equity funds, mutual funds, corporate VCs and sovereign wealth investors have had a staggering impact on the market. Last year, according to PitchBook, this group of investors pumped $500bn into start-ups globally, or twice as much as all the money invested by traditional VCs. This was up from only $180bn the year before.

Investors such as SoftBank and Tiger Global which have taken some big knocks may retreat, but will others be waiting to take up the slack? History, after all, suggests this is exactly the right time to put more money to work in the start-up world. Investors who piled in at the top of the last tech bubble, in 1999, took big losses — but venture money invested in the more sober period that followed is reputed to have brought stellar returns (though the lack of public data makes comparisons difficult).

All of this means that given the sheer scale of the bubble that is ending, venture’s realignment with reality will take some time. But as Klarna found out to its cost this week, the good times are most definitely coming to an end.

richard.waters@ft.com