Joanna Drake Earl
General Partner, Core Ventures Group
At Core Ventures Group, a Silicon Valley based venture capital firm with strong ties to Japan, we have been concerned about an overheated startup financing market since 2014. We witnessed the signs of a technology bubble reaching its peak and now, quickly deflating: start-up valuations are dropping 50%-75%, engineers are choosing higher salaries over more equity and real estate prices in San Francisco have dropped for the first time in 8 years.
In the midst of this start-up financing downturn, we would like to share what history has taught us about bubble deflation and implications for Japanese corporate participants. Because ironically, this deflation is occurring during a resurgence of Japanese corporate investment in Silicon Valley. In a case of unforeseen consequences, Prime Minister Abe’s rallying of Japanese businesses to engage with Silicon Valley has coincided with a dangerous phase – especially for recent entrants.
In our next posting we will share specific recommendations on how to navigate this downturn. Today, we would like to provide context on technology startup market cycles. Typically there are four stages of a startup financing downturn:
- Mixed Signals and Denial
- “Falling Knife”
- Capitulation and Market Bottom
Phase I of the current downturn began in early 2015. In this first phase of “Mixed Signals and Denial”, there is very little concrete data and companies have a hard time comprehending that the market has changed. The first to detect the market change are typically the most active professional venture investors. They see financings take longer than expected and disappointing results. Less active investors are the next to identify the downturn as their smaller data sets eventually show the same trends.
The last ones to detect the market change tend to be the entrepreneurs themselves and non-Silicon Valley investors . Since entrepreneurs are so focused on building their companies and only raise capital once a year, their market information is out of sync with rapidly fluctuating conditions. Meanwhile new investors from outside of the Silicon Valley ecosystem struggle to detect changing market trends. The limited information sources and experience of both players results in a brief period of “Mixed Signals and Denial” during which many companies and investors continue uncurbed investment valuations and spending.
By summer 2015, savvy industry players knew that the markets had in fact transitioned and that we entered the “Falling Knife” phase. In this phase, anyone with access to trusted market information realizes that “attractive” financings that increase a company’s valuation are unlikely. And that additional funding will require non-traditional investors and “creative” financing structures to save private companies running out of cash.
These non-traditional investors are typically from outside Silicon Valley and most often from abroad. In the fourth quarter of 2015, an increasing number of unusual financings occurred that included large investments from foreign investors but with little or no additional investment from a startup’s existing Silicon Valley investors. As a whole, US venture investment fell 30% in the first quarter from the three previous quarters. And 44% of start-up funding is now coming from non-traditional investors.
The term “Falling Knife” describes inexperienced investors who invest during this period of a bubble collapse, mistakenly thinking that they are gaining access to exciting companies at low prices, when in fact they are serving as a last resort for failing companies desperately seeking additional capital. Everything is fine if one can grab a falling knife by the handle, but any miscalculation can result in a nasty encounter with the blade.Read on Nikkei Site