A Q&A with IVP’s Steve Harrick on the VC market’s trajectory going into 2024
Steve Harrick is one of most experienced venture-capital investors on Sand Hill Road. He spoke with Jodie Bourdet, a partner at Cooley LLP, about the state of venture funding, investing in AI, and his advice to startup founders on how to navigate short-term pain ahead and come out this cycle strong.
(This interview was originally published on Lexology.com and has been edited here for clarity and length.)
Jodie Bourdet: Although we have begun to see a rebound in Q2 2023, global venture capital funding has fallen dramatically since 2020 and 2021. Is that due to the current state of capital markets for technology companies and to interest rates being higher, or are there other factors at play?
Steve Harrick: I don’t view the uptick as statistically significant. In 2020 and 2021, interest rates were at record lows, and it was an environment where people were being very aggressive in terms of capital deployment. That resulted in more companies getting financed at higher valuations and larger round sizes, meaning companies were taking on more capital.
What happened subsequently is that the public markets corrected dramatically – multiples compressed. There’s been a significant recovery over the last few months in the Nasdaq and tech stocks, but multiples, compared to where they were in 2020 and 2021, are much lower. Tech companies are not going public, but those that raised a lot of capital still have capital left, so they are saying: “We’ve got $70 million on the balance sheet, our last valuation was at $2.5 billion, we’ve got $40 million or $50 million in revenue, and if we went out to market, we wouldn’t be able to reach our last ground valuation.”
But the boards are saying: “Lower costs, grow more efficiently, converge on profitability, and don’t go back to market right now.” Because they’re trying to avoid a down round.
Over time, those companies will need to be financed, and if they can’t do it publicly, they’ll need to do it privately, so I think you will see down rounds increase in terms of frequency.
There is still a lot of capital available that has been raised by venture funds, but it is a difficult deal environment when the last round prices were as high as they were.
“There’s a frenzy in AI and ML right now, but people really aren’t sure who the leaders will be. It will take years to play out. But the software landscape has already changed permanently.”
Jodie: IVP is investing in companies at the forefront of AI, such as DeepL, Jasper, Grammarly and Traceable. How have recent developments in AI continued to shift your investment strategy, including outside of AI?
Steve: Machine learning (ML) has been going on since the end of World War II, and while this technology has been evolving for a long time, it has gotten increasingly sophisticated as processors become more powerful and cheaper. You can offload to the cloud, you can do neural networks and you can write algorithms that take in vast datasets. The advent of ChatGPT was really a kind of “coming out” time for this technology.
I worked at Netscape in 1996, and it was the same for the internet back then. You put a browser on the front end of the internet and made available to everybody what had previously only been available to academics. ChatGPT is now doing the same thing for AI. Everybody can use it, play with it, understand it.
There’s a frenzy in AI and ML right now, but people really aren’t sure who the leaders will be. I think you are seeing some vertical applications like DeepL get real traction. Traceable is using it for application programming interface (API) security. A lot of our portfolio companies, such as Grammarly and CrowdStrike, were using AI before it became enormously popular.
AI does affect our investment practice. We recently hired Tamar Yehoshua as a new venture partner. She was the chief product officer at Slack, and before that she led AI and ML initiatives for leading multinational technology companies. She is now heading up our AI efforts, which will affect all of our investment activity. But I really believe the long-term value will take years to emerge.
Software is going to get smarter. It’s going to be able to make more real-time decisions and deliver more value to customers. But if you are a customer, and I come to you with a hot new AI application, you’re going to say, “Show me how it works, show me why it’s different. Show me why, with a future release of ChatGPT, this won’t just be free for everybody to use.” You’ll naturally be skeptical, and I’ll have to show you the business value. That will take one to two years in some areas, 8 to 10 in others – but the tailwinds will be persistent.
Our belief is that the value of AI and ML will be enormous, but it will take years to play out. But the software landscape has already changed permanently.
“In the short term, it’s going to be painful – hard on liquidity, more down rounds, more rationalization of business, more mergers & acquisitions.”
Jodie:What current VC trends excite you and which cause you concern?
Steve: One of the things that excites me the most is a return to fundamental business building.
Resets and valuation downturns are painful. We’ve always been a cyclical business and we always will be. In down cycles, the old rules that govern commerce come back into play – meaning that you don’t just buy growth at all costs. You invest intelligently, keep customers happy, grow revenue, amortize costs over a bigger base and become profitable.
In technology, the markets give you a lot of leeway, because you’re doing something new – you’re creating a new market. Investors don’t ask you to become profitable right away. But eventually you must be. I think we will be able to run companies in a more responsible fashion than when you run them and say, “Whatever we spend, somebody will pay a higher price. So, let’s just keep spending.” That’s what was happening in 2020 and 2021 – and in other bubbles. I witnessed it in 1999 and 2000.
In the short term, it’s going to be painful – hard on liquidity, more down rounds, more rationalization of business, more mergers & acquisitions – all of that will take place. But it is going to be better for a company’s long-term health.
Other technology trends that are big include security, which is a big focus of mine. I’ve backed CrowdStrike, Anomali and Traceable, among others. Cybersecurity is a never-ending battle between offense and defense, and we need to secure data and protect it.
Another is infrastructure, which is always changing. How do you use open source effectively in commercial applications? What is old and not meeting the needs of current customers? What infrastructure is going to support AI most effectively? That’s an area where we’re spending time.
Jodie: What business advice do you most often give companies about fundraising?
Steve: I really like to ask the “use of proceeds” question.
If you raise a new round of capital, let’s say it’s $30 million or $40 million, and you’re at a certain point in your business, I like to ask, “What will this additional capital do for you? How will you use it? What will this company look like before it raises its next round, either publicly or privately?”
That tests their command of the business, shows how they will use capital and clarifies what the business should look like before it raises again. And it gives the venture capitalist confidence that the next round will be north of the current price they’re paying.
If someone can’t answer these questions, and they don’t know what they’re going to look like, but they’re driving a high valuation and they don’t have much revenue, that raises some flags for us. Because if they take your capital and use it inefficiently, then they’re going to come back to the market, and somebody’s going to say, “I can’t get to the price that IVP just paid.”
That’s the way venture capital has always been done responsibly: You raise capital, you invest it, you build your business and mitigate risk over time. By the time you go public, you can give guidance, and public investors can say, “OK, I understand, that’s a fair price. I’m going to buy into this company.”
And then you meet and exceed that guidance. That’s how you create value for everybody.
Jodie: VC financing started to rebound over the last quarter, as did the percentage of down rounds. Is this a fluke, or do you see further quarterly increases on the horizon?
Steve: I think you’ll continue to see the number of deals increase – meaning that companies that raise those rounds are starting to exhaust them, and they’re going to need to raise money at some price.
I think you’re also going to see the number of down rounds increase. Companies may be low on cash, they’ll need new capital, the last price was too high, they made progress but not enough to exceed the last round price. So, they’re going to raise money, but they’re going to have to take terms or a down round – or a flat round, if they can pull it off. The really great companies will still be financed in an up-round valuation, and I think that will be the rationalization of the financings that took place in 2020 and 2021.
The difference between other cycles is that – although the tourists have left, as they always do when markets contract – the consistent venture practitioners raised a lot of money that will eventually need to find a home. They must find a way over time to put that capital to work so it’s not going to cause the complete collapse of valuations, but people are going to be very selective.
“The best venture firms will build great, sustainable companies that will generate compelling returns long term.”
Jodie: Any other observations on this quarter’s VC data or other “gut feel” observations?
Steve: Fast money comes and goes. Hedge fund money was fast money – limited due diligence, no help, high price, “don’t call us, talk to our consultants” – and not the best way to build businesses.
But venture capital is an amazing business. Firms like IVP have a lot of experience in pattern recognition. When we invest, we are hands-on. We help companies hire, plan, monitor and manage their business.
The best venture firms will build great, sustainable companies that will generate compelling returns long term. But if anyone thinks they’re going to be investing and flipping something for a profit right now, they’ll be disappointed.
You must do this business because you love it. And creating value takes time. That’s what I’m comforted by in down cycles. It’s a time to build.
