As we speed through 2016, Silicon Valley Bank recently released its mid-year 2016 State of the Markets Report. As we came out of the blocks, the beginning of the year started with a great deal of volatility. And world events, from the Brexit vote to US elections to geopolitical uncertainty, have continued to impact investor moods.
The report, compiled by SVB Analytics, looks at how shifting investor sentiment is driving some healthy recalibration in the innovation sector. From my vantage point, the innovation economy is resetting expectations and strategies. Raising money and starting disruptive businesses are supposed to be hard things to do.
However, on the whole, the fundamentals driving innovation remain strong and investment is still flowing to those companies most likely to succeed. We also expect corporate venture capital to play an even bigger role during the recalibration, as the need for these companies to focus on innovation accelerates. Here is SVB’s view of the landscape, and a few predictions for the rest of the year.
The decline of the private IPO and unicorn valuations: Last year, late-stage companies opted to raise private capital rather than IPO. There were four times as many private IPOs – rounds over $100m – as IPOs. Both private IPOs and IPOs decreased in the first half of 2016, as some of the largest fund managers pared back investments. Still, the number of private companies with $1bn-plus valuations has tripled since 2014, with more than half of all unicorn value now concentrated in the top 12 “decacorns”. And while the pace of new unicorns has decreased, and many publicly-traded ones are trading below their final private valuation, investors continue to double down on the most promising companies.
Focus on profitability before IPO: During bull markets, tech companies focus on growth at the expense of profitability at IPO. Now, we see that investors are shifting priorities. Instead of growth, they expect IPO candidates to show strong unit economics and a clear path to profitability. As a result, companies are resetting valuation expectations and CEOs are paring costs to extend their runways in these leaner times. Marginal companies may be forced to reinvent themselves. An interesting side note – as tech companies are taking longer to go public, it is creating a growing need for employee liquidity workarounds to retain talent. We expect to see growing secondary market activity in the back half of 2016.
Doubling down on later rounds as IPO backlog grows: So where are investors placing their bets? They are focusing on the most promising companies, curtailing early-stage investments while doubling down on later rounds. In second quarter of 2016, the number of rounds continued to decline, yet total capital invested grew by $10bn compared with the first quarter. The pace of new companies reaching $1bn-plus valuations continues to exceed the pace of exits, creating a backlog of private companies. At the end of the first half of 2016, these companies had a combined market value of more than $550bn. To put that number in context, Apple’s valuation stands at $570bn.
Private companies acting like public ones: While companies are still cautious about going public and traditional venture deals are in decline, companies at all stages are finding innovative financing solutions, including alternative funding structures. Those private companies large enough to access debt, such as Airbnb and Uber, are continuing to do so at large amounts usually reserved for public companies.
When will the IPO window open? Since May, Twilio (cloud communications software), Acacia (optical interconnect technology) and Impinj (radio-frequency identification technology) have had successful IPOs. Their performances suggest a glimmer of renewed interest in IPOs. But reaching the IPO stage was hardly speedy for any of them. Twilio and Acacia were founded in 2008 and 2009 respectively, and Impinj was founded in 2000.
There are some encouraging signs that good companies are ready for IPO, but there does not appear to be sufficient investor appetite to erase the entire backlog. We are, however, seeing a new wave of M&A activity. Strategic and financial buyers are acquiring high-growth cloud software companies at attractive prices. Corporates are willing to pay for customer acquisition. Consider some recent deals – Unilever bought Dollar Shave Club for $1bn, Walmart paid $3.3bn for Jet.com, and Microsoft acquired LinkedIn for $26.2bn. The opportunity to accelerate corporate growth through acquisition complements the strategy of developing new technology internally.
Innovation fundamentals are sound – one in 10 retail sales in the US is an online purchase, says researcher Forrester, and total online retail sales are expected to jump 33% by 2020 to more than $500bn. And we are just touching the tip of the iceberg when considering the opportunities to use technology to transform traditional industries around the globe – healthcare, robotics, artificial intelligence, the list goes on. From my perspective, the focus on innovation shows no sign of slowing down and new and exciting companies are just getting started.