Current situation of the venture capital market: fierce competition, returns concentrated in specific areas

Original Author: DEZ

Original text compilation: Deep Tide TechFlow

What is the current situation of the venture capital industry? If you ask a venture capitalist for their view on the current market, you may hear the following three consistent opinions:

A) The market is too crowded

B) Extremely fierce competition

C) The return is concentrated at the top.

This is an interesting and consistent comment, especially considering the crucial role that venture capitalists play in the startup ecosystem. So, is venture capital a dying asset class? Absolutely not. But is it facing structural challenges? Without a doubt.

Let’s explore the reasons from a macro perspective.

As of 2024, three highly anticipated venture-backed companies have gone public: Reddit, Rubrik, and Ibotta. As of earlier this week, these three companies have enterprise values of approximately $10 billion, $6 billion, and $2 billion, and are expected to generate revenues of $1.2 billion, $922 million, and $415 million, respectively, in the next twelve months.

These companies are large, well-capitalized, and well-known enterprises with thousands to millions of loyal users. These companies have crossed the so-called “divide” and are striving to become efficient publicly traded companies. These billion-dollar success stories are the dreams of venture capitalists and can greatly enhance our careers.

However, despite the fact that in the long run, return on capital is the only important thing for venture capitalists, we (as an industry) are still very willing to pause and doubt when it comes to the core part of our work - pricing.

In the past few weeks, the early-stage startup landscape has continued to diverge into two types: AI-native companies and all other companies.

AI native companies focus on application, inference, and cutting-edge / Depth technology model layer. These companies, such as Hebbia, recently raised funding with a valuation of 700 million US dollars, Cognition Labs is now valued at 2 billion US dollars (amazingly, only 6 months later), Harvey is reported to be completing a round of financing with a valuation of 1.5 billion US dollars.

In fact, we do not live in a financing environment with very few of these valuations. In fact, they are quite common. There are other companies such as Glean (valued at $20 billion), Skild AI (valued at $15 billion), and Applied Intuition (valued at $60 billion) that are also reinforcing this trend. I am particularly familiar with Hebbia, Cognition, and Harvey, these three companies, they have several advantages:

• They are making money: reportedly, Hebbia’s revenue is 13 million dollars and has achieved profitability, Cognition’s revenue may be between 5 million and 10 million dollars, and Harvey’s revenue exceeds 20 million dollars.
• They are building their brand and talent density: if you look at their employee composition, you will find many graduates from Ivy League schools and technical Seasoned Traders.
• They have well-known brand customers: such as PwC, KKR (Kohlberg Kravis Roberts & Co.), T-Mobile, Bridgewater Associates, U.S. bearish traders, Centerview Partners, etc.
• They represent the evolution of application software: following the work results more closely instead of the work process (i.e., do not help me complete the work, just complete the work for me)

However, despite the questionable unicorn valuations, they are firmly in the “gap”. There is no guarantee that they will survive until the day they go public. The competition in this field is very fierce. The technology they build may tend to be stable and unable to provide sufficient investment returns for their ultimate customers. In addition, their peers in listed companies are 20 times larger in revenue scale, have clearly established themselves as market leaders, and are valued at 5 to 8 times future revenue in the next 12 months, rather than 20 to 100 times future revenue valuation.

This is the structural challenge facing the venture capital industry: there is too much capital, but few high-quality assets to invest in, leading to unsustainable valuations pump and ultimately damaging equity value. However, some of these crazy valuations may turn out to be relatively cheap in hindsight. Today, there are indeed some truly enduring, intergenerational companies being built, but no one can clearly distinguish which will be the Webvan and which will be the Doordash.

(Translator’s note: It is difficult to predict which companies will ultimately fail and which companies will achieve great success.

Webvan: an online grocery delivery company, founded in 1999, but due to mismanagement, underestimation of market demand, and other reasons, it eventually went bankrupt and closed in 2001. Webvan is often used as a typical example of entrepreneurial failure.

Doordash: An online food delivery platform, founded in 2013, rapidly expanded and eventually went public in 2020, becoming a company with a Market Cap of tens of billions of dollars. Doordash is a typical representative of successful entrepreneurship.

Companies like Doordash have brought substantial returns to their investors, which in turn has sparked a new round of interest in venture capital as an asset class. This cycle continues to repeat, and by 2040, we may be discussing a new investment technology that will also exhibit similar price dislocations. This is the current state of venture capital. To further illustrate this point, I think several themes about the current state of venture capital are very clear:

1. We are currently in a low liquidity period, near the bottom of the market cycle. 2022 is the year with the fewest IPOs since the global financial crisis, and there is no obvious improvement in 2023.

2. Application software has always been a gift that keeps on giving, accounting for 8% of all IPOs since 1996. However, as a sub-industry of venture capital, it is maturing. As a result, the available market opportunities are shrinking.

3. Venture capital has never been so competitive. In the past 20 years, this asset class has risen by more than four times. This truly reflects the principle of ‘your profit margin is my opportunity’.

4. For assets considered to be unique, price is no longer a consideration. A 100x revenue multiple is accepted and increasingly common.

If I had to simplify my core argument, it’s that when you turn $7 million into $4 billion, it often attracts competition, and competition is a determining factor in the current state of venture capital. Pricing, transaction speed, and the intensity of the transaction process all stem from competition, and today’s dynamic in the venture capital field is fully demonstrated through the ‘Tale of Two Cities’; where there are AI-native companies and all other companies.

The real question now is, if this is the current state of venture capital, then what? I have my own ideas and strategies being implemented, but I will now keep these ideas. At the same time, I wish everyone a happy week and smooth investment.

To avoid confusion, I did not speak directly with these companies. These figures are estimates I have gathered from public records and private conversations.

It should be noted that I am not saying that these are prerequisites for success, but they are strong early indicators of talent density aggregation.