Tech Startup Funding Hits Record - it’s Not Just VCs Driving the Growth. CEOs Must Increasingly Embrace the ‘Non-Traditional Investor’
“Today, among the top 10 investors in startups by dollar amount, half are nontraditional venture investors, including Fidelity Investments Inc. and Tiger Global Management. The number of startup funding rounds that include nontraditional VC investors and zero venture-capital firms has doubled over the past 10 years, according to PitchBook.”
Growth-stage Funding is Soaring - But Much of this Growth is Being Driven by ‘Nontraditional’ Investors
We recently passed the midway point in 2021 and already tech startup investing is hitting record levels. As recently reported in the Wall Street Journal, “Investment in U.S. startups for the first half of 2021 hit $150 billion, eclipsing full-year funding every year before 2020, according to a report from PitchBook.” Who could have guessed just a year ago that this would be the case? This time last year businesses across the globe were closed down, and the future of the economy was still well in question. Now, the US stock market is hitting all time highs, and funding for private markets - particularly growth-stage and early-stage companies - is soaring.
However, the aspect of this article that caught my eye was that a significant portion of the funding is coming from nontraditional sources. As detailed in the article, “Hedge funds, mutual funds, pensions, sovereign-wealth groups and other so-called nontraditional venture investors were more active in the second quarter than in any previous period, according to research firm PitchBook Data Inc. These firms participated in 42% of startup financing deals, and those deals accounted for more than three-quarters of the invested capital, according to Pitchbook.” This is quite an interesting development. Nontraditional investment groups like this have been active in the space for decades. However, the high percentage share of the deals that they are now involved in is surprising.
If you are the Founder of a growth-stage business, you should keep a close watch on this trend as the ‘big name’ players begin to change. From the article, “Today, among the top 10 investors in startups by dollar amount, half are nontraditional venture investors, including Fidelity Investments Inc. and Tiger Global Management. The number of startup funding rounds that include nontraditional VC investors and zero venture-capital firms has doubled over the past 10 years, according to PitchBook.”
I have been writing for years about the changing trends in how companies fund growth. Relative to history, growth-stage companies now stay in private hands longer, and go public at a far lower rate. Given this trend, Founders of growth-stage companies must now have a greater understanding of the numerous sources of funding for their growth. Increasingly this growth is being funded outside of traditional venture capital and private equity channels.
In general, increased sources of funding for growth is good news for Founders. However, there are some aspects of this trend that warrant caution.
Are Underwriting Requirements and Standards Loosening?
Many traditional venture capital and private equity investors disparagingly refer to nontraditional investors as ‘dumb money’. Name calling aside, the argument is that many nontraditional investors have not been in the ‘growth-stage trenches’ - learning the lessons. Therefore, they do not have the requisite experience and skillset to successfully navigate early and growth-stage private investing.
I am not sure if that is completely accurate or not. However, this article does highlight some worrisome behavior by some players in this space. From the article, “The large asset firms have massive pools of capital, move quickly and are less likely to ask for board seats or involvement in company decisions, often making them more appealing to founders, according to interviews with investors and startup executives. The result has been a dizzying pace of deal making.” Venture Capital funds (and Private Equity Funds) generally require a seat on the Board, particularly for large investments. This is just common sense. It allows the investor to take a more active role with the company. Theoretically they take that Board seat to help guide the company, offer expertise, and perform their fiduciary duty to their limited partners (at least in theory). I realize that every situation is unique. However, if I am a limited partner investor, I am more comfortable if my General Partner has a seat at the table. The decision by these firms to not require board seats may not be a healthy trend.
In addition, anecdotes abound in this environment of the loosening of traditional due diligence requirements. From the article, “The shift to high-velocity investing has given founders more leverage. Some have scrapped pitch decks—the once-requisite company presentation for a prospective investor—instead showing up to investor meetings empty-handed.” Unfortunately, there are also stories of traditional venture capital funds feeling the need to compete for deal flow. As described in the article, “Some traditional venture firms are scrapping old practices to keep pace. To move quickly, some venture capitalists said they are cutting back on audits and customer checks, and taking a startup’s word on profit and loss.”
I realize that these are just anecdotes, and may not be representative of the type of investor behavior out there. However, these anecdotes, if true, should give investors pause.
“All that money has sent valuations soaring, which boosts profits on paper for all types of startup investors and their founders. Five years ago, 14 startups attained valuations of $1 billion or more during the April-through-June quarter, according to CB Insights. This year, 136 companies achieved that valuation during the three-month period.”
Potential Lessons to Take Away
First, nontraditional investors moving into growth-stage and early-stage investing is NOT going away. They can’t go away. The nontraditional investors - such as Fidelity - have clients with significant amounts of cash. That cash needs to be invested and put to work in growth-stage companies. Guess what? Most of those growth-stage companies are not publicly-traded, and likely never will be. Therefore, these large, nontraditional investors have little choice but to further engage private markets deals like these.
If you are a Founder, you will have to work harder to understand the goals and requirements of these nontraditional investors - and incorporate them into your company’s capital markets strategy. It is great that there are potentially larger pools of capital out there to fund your company’s growth. However, your management team will need to dig deeper, network further, and build out relationships to more of these nontraditional funding sources.
The bad news is that it will take more time and work on your part. The good news is that the valuation environment for your company has never been more favorable. As detailed in the article, “Nontraditional investors tend to have larger capital supplies and lower return thresholds than traditional venture firms, which gives them more wiggle room on valuations. Deals led by nontraditional investors have valuations that are on average five times the valuations in deals led by traditional venture capitalists, data from PitchBook show.”
If you are a traditional growth-stage investor, you will have to work harder to understand and accommodate these larger pools of capital, and adjust your strategy accordingly as well. The competition for lucrative investments - at valuations that you can stomach - has never been greater. From the article, “All that money has sent valuations soaring, which boosts profits on paper for all types of startup investors and their founders. Five years ago, 14 startups attained valuations of $1 billion or more during the April-through-June quarter, according to CB Insights. This year, 136 companies achieved that valuation during the three-month period.” Gain access to the right company, at the right time, at the right valuation, and the ability to grow that company to Unicorn status has potentially never been more likely. Get the valuation wrong however - well, you know the rest.
It should be interesting to see how it all plays out…
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