Below is the investor letter we shared with our LP’s a couple of weeks ago. Since we’ve heard ourselves repeating a lot of the items in here, we thought we’d share more broadly. In some places you’ll see “[…]” where we had to remove a couple of sentences of confidential information, but all the main points should come across.
To our investors and friends,
As we conclude the year, we want to take this opportunity to look back on a pivotal twelve months for CoVenture. We also want to share our observations from 2015 and 2016 predictions for the venture capital market as well as related sectors.
Year In Review
CoVenture
At CoVenture over the last year, we invested in eleven new startups, saw nine of our portfolio companies raise follow on financing, fully deployed CoVenture II, LLC and began investing out of CoVenture III, LP. We also brought on Michael Beller and Thatcher Bell as full time general partners (they joined CoVenture as Venture Partners in 2014).
Our portfolio companies have continued to perform well and our […..] We believe the metrics of our portfolio companies have justified these increases in value, and we are flattered to be co-invested with some of the top venture firms in the world. That said, our returns to date are almost entirely unrealized, so while we remain pleased with our progress, there is still a long road ahead for our companies.
Finally, many of the companies in which we’ve invested have been sourced from our friends in the venture world; firms such as […] have been especially helpful to us. These firms often send us companies that are too early in stage, but that they otherwise find interesting.
Overall, 2015 was a year of expansion for CoVenture: expansion of the team, of the portfolio, of our relationships in the startup and venture communities, and of the value of our funds.
Venture Capital
Although 2015 was a robust year for venture capital investments, exits, and fundraising, we saw signs of caution during the second half of the year. While dollar volumes for new seed and early-stage deals remained high relative to the last few years, the number of transactions dipped. Similarly, M&A values sustained recent highs, but the number of deals trailed off near year-end. These trends signal concern on the part of investors and boards; companies able to attract capital raised larger rounds and those that could command a fair price sold (or went public) rather than waiting for a better offer. Meanwhile, the number of new VC funds remained high, but dollars raised began to show instability in the latter half of the year.
Angel/Seed Rounds Get Bigger and Drop off in 2H 2015
Source: Pitchbook
Early Rounds Get Bigger and Less Numerous in 2H 2015 and Q4 volume dips to lowest level since 2010, while average round size peaks
Source: Pitchbook
IPO Volume Off from 2014
Source: Pitchbook
M&A Activity Still Robust But Off 2014 Peak and Reported values still large relative to pre-2013 activity
Source: Pitchbook
Busy VC Fundraising Year Showed Blip in Q3
Source: Pitchbook
Beyond Venture Capital
More broadly, in 2015 we began to see some signals of markets coming back down to earth. Corporate bond markets have started to curtail and leverage ratios have started to recede from a peak in 2014.
This apparent return to rationality is likely a leading indicator of declining purchase multiples as well (which surpassed 10x in 2015, according to CapitalIQ). This decrease in purchase multiples will ultimately impact both public and private equity markets. In short, with cheap debt less readily available, valuations in equity markets are likely to come back down, making it a buyer’s market again.
Importantly, regulatory changes since the financial crisis may exacerbate the choppy waters we expect to see in 2016. Increased regulation on banks has made it more difficult for them to purchase securities from clients, and thus introduced illiquidity into traditionally liquid markets.
Further, much of the financing formerly handled by banks is now being undertaken by non-traditional financial institutions (think marketplace lenders, hedge funds and private equity firms). These firms have become increasingly important parts of the financial system, yet are harder to regulate and are more diverse in nature. We believe these new financial players, especially upstarts looking to push growth, may run into trouble as default rates rise and credit models that have not yet seen a downturn are tested for the first time.
Looking Ahead to 2016
CoVenture
In 2016 we look to continue our investing pace, attracting the best entrepreneurs and bringing them the perspective and resources they need to realize their product visions. Our investing themes will be influenced by our expectations about the venture market and beyond, but we feel that our focus on domain expert founders is the right one in any market environment.
[…]. Our goal is to take advantage of our follow-on rights in the existing portfolio for the benefit of our investors, and to continue the pace of our initial cash-and-service investments beyond the current fund.
Venture Capital
As of this writing, the NASDAQ Composite is off approximately 10% in just under a month of trading in the New Year. Even before this drop, as noted in our look back at 2015, the IPO market was already showing some signs of slowing from its new issuance high in 2014. It therefore seems likely that IPOs will be off even further in 2016. At the same time, the devalued currency of public companies and likely conservatism of their boards in the face of a potential economic slowdown will create a drag on venture-backed M&A activity, except for the obvious accretive, cash-flow-positive combinations.
This reduction in exits will trickle down to private venture transactions as well, as first later-stage, then early-stage, firms reserve for and deploy capital into obvious performers — both inside the portfolio and in new deals — even more judiciously. We and other pre-seed and seed-stage investors are therefore well-advised to focus on companies that are capital efficient and quick to generate revenue, thereby attracting attention from a more conservative investing market.
Beyond Venture Capital
In the paragraphs below, we offer some predictions for the year ahead beyond the world of venture capital. These represent mostly minority positions within our team; e.g., not everyone at CoVenture agrees with any one of them. In aggregate, though, they represent a useful subset of some of the more controversial — but defensible — of our predictions for the New Year.
Virtual Reality Comes Into the Mainstream
2016 will be a big year for virtual reality, with the HTC Vive, Sony Playstation VR, and Oculus Rift all scheduled to ship in the first half of the year. Together with the recent launch of the Google Cardboard and its partnership with the New York Times, these new products will introduce virtual reality to the world. By the end of the year, you and most of the people you know will have tried virtual reality. Early adopters will own one of these devices. Don’t be surprised to see that early uses — as with many other technologies — include gaming and adult content. We also expect a variety of enterprise VR applications, perhaps in health care, real estate, or engineering. We at CoVenture saw a virtual reality investment opportunity (in sports media) in 2015, and expect to see more this year. We believe 2016 will end with VR devices on many holiday shopping lists, and will be just the beginning for this new technology.
Computer Science Becomes the Fourth “R”
New York City recently announced a 10-year, $80 million initiative in partnership with CSNYC to make Computer Science education a requirement for all public school students in the city. In so doing, New York joined Chicago and Los Angeles as major school districts that are working to ensure all students learn computer science. As NYC Public Schools go, so goes the country. Expect other major districts, and probably school systems in other countries, to jump onboard in 2016. CoVenture is excited about this trend in general and specifically because of our investment in Vidcode, a leading provider of computer science education software and courses. Toward the end of the year, Vidcode added […] as a formal adviser.
The CleanWeb Emerges
What do AirBnB, Nest, and Lyft all have in common? All have grown rapidly, creating tremendous value for shareholders and users in short order. All are also helping to increase efficiency and reduce resource usage — less energy, fewer cars on the road, higher utilization of housing stock, etc. through the application of new information technologies. These are CleanWeb companies. The recently-inked Paris Agreement, together with even more Middle-East instability driven by the increasingly overt animosity between Saudi Arabia and Iran, will encourage further innovation in resource-related technologies in 2016. Indeed, the World Economic Forum ranked climate change the biggest threat to the global economy in its Global Risks Report for 2016; the first time in the 11-year history of the report that an environmental issue has been so named. Don’t expect entrepreneurs and investors to repeat their capital-intensive mistakes from the prior Clean Tech boom, though. Instead, we believe we’ll see more CleanWeb companies — entrepreneurs applying software to drive smarter, capital-efficient use of resources in agriculture, water, energy, and transportation.
Compliance in Untested Financial Institutions
Marketplace lenders have begun using alternative data sets to assess credit risk and have been largely successful since 2008. But these models have only assessed risk in a historically strong period for consumer credit. As markets become choppier in 2016, many emerging financial institutions will be tested for the first time — and it will only take one serious breakdown before they begin facing greater regulatory scrutiny. Both the government and private investors will demand more rigorous systems, processes and reporting and we believe private companies capable of supporting compliance with these new expectations for lending platforms and their participants may become the rating agency of a new financial era.
Paid Content Makes a Comeback
There is a current misalignment between readers and publishers. Readers are no longer paying for their content, and are therefore no longer the customer of the news they consumer — advertisers are. To the detriment of the veracity and utility of most consumer content, publishers have become increasingly adept at serving their real customer. Media companies produce content that is not purposed to inform, but rather to attract eyeballs and pageviews. As readers become more frustrated with the content they read, we believe consumers will once again begin paying for long-form and high quality content — recreating alignment between the reader and the publisher. Two drivers in 2016 may become the election (which catalyzes traditionally sensationalist content) and Virtual Reality, which will provide a “next-level” content consumption experience.
Conclusion
We feel that we are transitioning from a time of (sometimes irrational) exuberance in the venture capital and technology markets to a year of more (sometimes irrational) anxiety. Even so, economic dislocation, together with continued technological innovation across industries, promises more fertile ground for entrepreneurs, particularly those with the experience and resources to recognize and seize the resulting opportunities. We are working to find and partner with them.
