Are late stage mega deals draining capital from smaller startups?

Quantity does not always equal quality. But when it comes to venture capital and startups, more often means more likely.

In other words, given the high risk and thus high fail rate of startups, a robust supply of startups ensures at least some will survive to eventually becomes unicorns, get bought, or go public. That’s the reason why venture capital firms make lots of bets, knowing most will fail but perhaps a few will see an exit.

At least that’s how venture capitalists used to operate. Today, investors are focusing their money on late stage, already large companies, creating unicorns or turning unicorns in mega unicorns. The results are fewer deals but ones with large valuations.

The data bears this out. U.S. deal activity fell to its lowest level since 2013, though later-stage mega-deals pushed annual funding to its highest level since 2000, according to the latest PwC/CB Insights MoneyTree report.

Over the past three years, the number of U.S. deals dropped 9 percent to 5,536 from 6,098. At the same time, the United States is currently producing record numbers of unicorns. But what then?

The first wave of mega unicorns like Uber, Lyft, Pinterest, and Slack are likely to go public this year. Who will replace these companies over the next decade or two?

Straying from the roots of venture capital

Companies are not born as unicorns. They need funding to gradually grow in to the type of companies that will attract multi-billion valuations. We need a pipeline of such companies.

The emergence of mega unicorns suggests that the role of venture capital has changed. The first VCs in the 1960s and 1970s provided money to high risk tech startups because these companies could not get funding from traditional sources like banks and government agencies like the Small Business Administration.

But given the mega successes of companies like Google and Facebook, investors, including corporations, pension funds, and university endowments, have flooded growth firms with money. But instead of young startups that need it the most, investors are directing cash towards already well funded late stage companies on the brink of an IPO or acquisition.

You can see why. Companies like Uber and Airbnb have already validated their business models and therefore don’t pose as high of a risk as an unproven startup still developing its technology. But isn’t that point of venture capital, to take big risks?

Funding late stage companies that have largely proven themselves is easy. At that point, investors are mostly looking for a quicker return. Backing the startup in someone’s lab or garage that might never see the light of day requires courage and resilience.

Recovering the spirit of entrepreneurialism

Perhaps there’s another reason for the fewer number of deals. Enterpreneurialism in the United States is on the decline.

Overall business creation today remains far below levels before the Great Recession, according to the U.S. Census Bureau. In 2016, the country boasted 756,000 firms one year or younger, a 17.6 percent drop from 1978.

Research universities seem like natural launching pads for startups. But In 2016, the most recent available data, universities launched 1,012 companies, just 1.1 percent more than the previous year even though the number of patents awarded to schools jumped 5.1 percent, according to data from the Association of University Technology Managers.

Moreover, younger people, a demographic we most associate with risk-taking and entrepreneurialism, are starting fewer companies.

In 1996, people between the ages of 20 and 34 accounted for 34.3 percent of entrepreneurs, the largest of any age group, according to the Kauffman Foundation. Nearly two decades later, that number fell 9.3 percentage points to 25 percent.

Meanwhile, in Asia, the continent most capable of challenging the United States for global tech supremacy, the region has enjoyed strong growth in both raised capital, including mega rounds, and number of deals. Last year, Asian startups attracted $81 billion through 5,066 deals, compared to $45 billion via 2,425 deals in 2015, according to the MoneyTree report.

For the United States to preserve its tech dominance, we need investors to fund both well developed unicorns on the verge of an IPO/acquisition and early stage startups out of the gate.

 

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