By SCOTT MARTIN
Venture-capital investors scaled back funding of startups in 2016, capping a year haunted by overpriced private valuations and wariness of taking companies public.
Funding for U.S. startups fell 32% in 2016 to $52.4 billion, the steepest annual drop since the 2001 collapse after the dot-com bubble, according to data from Dow Jones VentureSource.
The trend raises the prospect that more tech companies will struggle to raise the necessary capital to sustain operations, leading to layoffs and adding pressure to be sold. Indeed several high-profile flameouts emerged in 2016. Billion-dollar-valued Mode Media Corp. shut down, once $2.7 billion-valued Powa Technologies imploded and Delivery Agent filed for bankruptcy. Fire sales of also-ran previously highly valued companies included LivingSocial Inc. and Gilte Groupe Inc.
Venture capital’s pullback also embodied investors’ cautious stance following a funding frenzy that drove soaring valuations and unleashed another digital gold rush.
Meteoric valuations have come back to earth as a result. In 2016, the median valuation of U.S. startups fell to $16.9 million from $53.4 million the previous year.
“The unusual private-market froth has come down,” said Byron Deeter, a managing partner with Bessemer Venture Partners. “Reactions among entrepreneurs and investors range from acceptance to denial to grief.”
Startups’ cash-burn rates have come under increased scrutiny as investors tightened their focus on financials.
Late-stage investors, which backed mega-rounds in the likes of Airbnb Inc. and Uber Technologies Inc., retreated from the tech scene. Mutual funds that got in on the action that drove values to blistering heights cut the value of their stakes. The past year’s investments from late-stage investors dropped 44% to $27.5 billion compared with in 2015. “You could argue 2014 and 2015 were overheated in terms of the late-stage rounds,” said Ajay Agarwal, a managing director at Bain Capital Ventures.
New entrants to the billion-dollar club of startups, or “unicorns,” also waned. Last year, 24 companies joined the ranks of unicorns, compared with 81—more than one a week—that joined in 2015, according to data from The Wall Street Journal’s Billion Dollar Club.
Some late-stage investors faced the unpalatable prospects of overvalued startups coming to the public markets at a discounted value to their last private-investment round. “The compression in the public multiples was a jolt of reality,” said Peter Sonsini, general partner at NEA. “You saw some of the crossover investors pulling way back, realizing the music had dropped off.”
With the run-up in valuations, the rise of so-called dirty terms in investor term sheets offered to startups became more common to ensure downside protections. AppDynamics in December filed to go public, revealing downside protections known as ratchets. Those terms ensured the startup would issue additional shares to some investors should the offering price below its last private round.
Ratchets and other downside protections tied to IPOs for billion-dollar-plus-valued startups increased through 2015 until the fourth quarter, when they appeared in 50% of venture rounds that valued companies at $1 billion or more, according to data from law firm Fenwick & West. Many of these companies, like AppDynamics, are now looking at public options.
Other protections that signal a chillier funding climate include participating preferred stock—or offering an investor two times their money before others can tap in—and multiple-liquidation preferences, which grant increased dividends.
“That’s what happens when sentiment moves slightly more negative,” said Brian Neider, a partner at Lead Edge Capital. “As the ball moves more into the investors’ court from the companies’ court, it’s only natural that the terms might change.”
Still, IPO scenarios remained unattractive. Some 37 debut deals came to market in 2016, a 46% decline from the previous year. IPOs raised $2.82 billion in the past year, compared with $6.45 billion in 2015.
To be sure, the mergers-and-acquisitions scene was a bright spot. Such deals, including buyouts, jumped 42% to $85.45 billion in value in 2016. Celebrated sales for venture investors included Stemcentrx Inc., Jet.com and Dollar Shave Club. Venture investors say the upshot of valuations hitting a ceiling is corporate acquirers in need of innovation are paying closer attention to startups.
Dollar Shave Club, bought by Unilever for $1 billion in July, was incubated at Science, a Los Angeles-based venture and incubator firm. “We have LPs now that have deep interest in Los Angeles and Science for delivering returns,” said Mike Jones, co-founder and CEO of Science.
VentureSource counts funding rounds for U.S.-based companies with at least one venture-capital firm as an investor. It doesn’t include startups only backed by individuals or majority-owned by corporations or private-equity firms.
Write to Scott Martin at scott.martin@wsj.com. Follow him on Twitter at @scottysmartin Yuliya Chernova at yuliya.chernova@wsj.com. Follow her on Twitter at @ychernova
