Told you we weren't in a bubble: Venture capital off significantly in 2012

By Sarah Lacy , written on October 19, 2012

From The News Desk

The arguments that we're in a bubble just evaporate by the day.

Pre-2011 the argument was inane because no one had exited. You can't have a bubble when no one has actually made any money. Oh! But the bubble IPOs were coming! You can tell by the secondary markets! Just wait!

Post-LinkedIn's IPO the argument was inane because the argument was based on exactly one company's exit, and that company had been around for 10 years and had a pretty solid business. Also, PE ratios of tech companies were trading at about the level of bankrupt steel mills. But it's just the first one! Wait until Facebook! If LinkedIn did this well, Facebook will be Netscape!

Then Facebook went public and tanked. Groupon, Zynga, Pandora all traded down much lower than their offering prices. LinkedIn was still pretty much the only one -- at least in the consumer world. In the face of the thing they kept claiming would happen decidedly not happening, I thought that'd be the end of it. I was wrong. Oh! But private valuations are still high! Those companies have to have somewhere to go! That one came from Nick Bilton of the New York Times who -- just days after the Facebook IPO clusterfuck -- was still arguing we were in a bubble. If the previous arguments were paranoid, this one was just nonsensical.

Well, the last leg of the argument that was never true and never made sense has finally been knocked out from under the bubble-wailing Greek chorus of Silicon Valley: Venture capital is declining too.

According to new numbers by the NVCA and PricewaterhouseCoopers, Venture capital investments fell 11 percent in the third quarter in terms of dollars and 5 percent in the number of deals compared to the third quarter of last year. 890 deals raised $6.5 billion versus $7.3 billion over 935 deals last year.

Now, this isn't a massive decline, and it's hard to read too much into quarter-by-quarter numbers. But investment for the first three quarters of 2012 is well below where it was last year. Even the usually glass-half-full NVCA is saying 2012 will likely fall short in terms of deal volume and dollars, citing an overall industry pull back.

Particularly in decline are investments in seed and early stage deals. That's typically a sign of decreased optimism in where the industry is going and a sign that VCs feel their existing portfolios need some TLC. Or as it was euphemistically called in the aftermath of the actual bubble, "triage." "The decline in funding for Seed/Early stage companies is firmly in place -- we've seen a drop in dollars and deals both quarter-over-quarter and year-over-year," said PwC's Tracy Lefteroff in the release.

A lot of that is coming from fewer venture funds being raised and an overall shrinking in available capital out there, says the NVCA.

Guess what falls when all of those things decline? Valuations. Private company valuations have little to do with how a company is actually doing. It has to do with two things: Optimism for the future and the balance of power between the entrepreneur and investors. When there's less money chasing hot deals, no one has to pay as much. No one pays that much when they don't have to.

Now, it's funny: I'm looking out my window in San Francisco, and I'm not seeing restaurants going out of business. I'm not seeing massive billion dollar public companies going under and thousands of people per company being laid off. I'm not seeing hundreds of companies being delisted from the NASDAQ. I'm not seeing thousands of people suddenly having to leave San Francisco and move back in with their parents. Take exactly three companies -- Facebook, Zynga, and Groupon -- out of it, and we're not even seeing billions in evaporated market value.

That's because -- as I've been now saying since 2006, when YouTube was purchased for $1.65 billion, and Facebook raised a round at a $500 million valuation -- this is not like 1999.

Indeed, just as the nonexistent bubble that was constantly spotted in the last six years didn't remotely lift all boats, so too is the nonexistent popping of that imaginary bubble not widely hurting tech. Workday has surged in its IPO, and so have smaller issues like Shutterstock.

As I wrote earlier this week, it's just consumer Internet companies that the market hated. That's a big reason one-quarter of all the deals in the third quarter were for software companies, not consumer Web deals. Software got more funding than any other industry.

I am not saying now -- nor have I for the last few years -- that private company valuations have been rational or that there wouldn't be a correction. I just said there was no evidence of it spilling into the broader economy and the broader markets in a big way. Bubbles are by definition mass-economic phenomena. By that metric, the people screaming bubble have been utterly wrong on every front. It never impacted the overall economy, it never took control of the stock markets, it never even jumped into another sector of tech. Wrong. Wrong. Wrong. Wrong.

That's not to say it won't have repercussions for our industry, and that's what we're starting to see now. They'll be big, and hard truths will start coming down on an industry that has mostly been rolling in good times for a while. VCs will have to write down the value of their portfolios, which will put a damper on the funding spigot. Firms are already advising companies to bulk up on cash and ensure they have a good runway for the next 12 months -- just in case it all gets worse. That means we'll see a flurry of companies competing for Series A and B and C rounds at the time when VCs are starting to pull back. A lot of companies just won't get money, and even in failure-adverse Silicon Valley there can't be acqui-hires for everyone.

Potentially worse is the prospect of sweeping down rounds, when a company's valuation declines from the last round, employees' options get crammed down, and morale suffers. It's the downside of aggressively trying to reach up into the $1 billion club when your business prospects just aren't there yet. Everyone seems to forget about it when valuations are frothy, like you underestimate the impact of that last tequila shot at the bar...until the next morning when your alarm goes off for work.

And in case you need to hear this in music form, check out our bubble song below.

[Image courtesy thethreesisters]