Investing in startups will get riskier

Startup investing will become riskier than ever

Finance

To venture means to undertake risk and danger. The inherent unpredictability of technology investing is what gave the modern venture-capital industry its name. But in recent years, as investors have exuberantly chased the huge pay-offs that can come from tech, the perceived dangers of startup investing have receded. With interest rates low, there are few alternatives that offer returns as high as successful startups can. The allure of tech glows brightly, like a smartphone screen in the pitch black.

In 2018 investors will be taught that technology investing may hold great promise, but not without peril. Expect to see some prominent startups flop in the year ahead. These will serve as cautionary reminders for ­besotted tech investors.

Tech’s popularity is, perversely, a big reason why the investment climate will prove risky. Silicon Valley’s best investments used to be claimed by a small brood of well-connected venture capitalists on Sand Hill Road, which had the power to buy large stakes in startups at relatively low prices. But now many investors new to tech, such as sovereign-wealth funds and big companies, are throwing huge sums of money at uncertain enterprises and bidding up the prices of deals. This could not only hurt returns for traditional venture capitalists, who have to pay more for their stakes; it could also damage the prospects of success for the startups themselves. Loads of money can be distracting and distorting for tech entrepreneurs and can play a role in a startup’s demise.

Take Uber, a ride-hailing giant. One of the many reasons why Uber stumbled in 2017 was that it had access to too much cash and did not learn to be disciplined. It became the most highly valued private company in America and accepted huge investments from some investors new to the tech scene, including $3.5bn from Saudi Arabia’s sovereign-wealth fund.

The piles of money rushing into the sector will only grow larger in 2018. At one extreme is SoftBank, a Japanese firm, which has raised a $100bn fund to invest in tech companies. Because its fund is so large, SoftBank has to write enormous cheques; that is skewing the amount of capital startups are able to raise in their later stages. WeWork, a startup that offers flexible workspaces, raised a whopping $4.4bn from SoftBank in 2017.

The more money that large investors like SoftBank plough into such ventures, the longer they are able to stay private and avoid an initial public offering. This elongates the time before early-stage venture capitalists can get their money out and can add risk to their investments, because later investors may receive preferred shares and guaranteed returns. As venture capitalists hold their stakes longer, it also hurts their annual returns, since any profits are spread over more years.

Into the unknown

Some parts of the tech industry, such as artificial intelligence and autonomous cars, have become so popular that it is difficult to make investments in startups, because valuations are so high. Young enterprises are valued dearly even though many of them have no revenue.

It has also become difficult to be a canny tech investor, because after the rise of the cloud and mobile it is not obvious which platforms are going to come next. “The risk profile of tech has gone up. There are no clear next platforms, so investors are fishing in more speculative areas they don’t know as much about,” says Alfred Lin of Sequoia Capital, a venture-capital firm. Some investors with expertise in spotting promising internet and software companies are turning their sights to biotech and health diagnostics, where they have no track record and success is impossible to bank on. This mentality will lead many venture capitalists and tech tourists into bad deals. In 2018, exuberant tech investors should not be surprised to see many unhappy returns.

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