Follow the Leader: Venture Capital Pandemonium

Background  

In every aspect of life, there are people who tend to offer up a perspective and others who like to listen and be engaged. When someone is a foodie, you often take their restaurant recommendations; when someone is a huge sports fan, you take their suggestions on who to draft in a fantasy pool. This theme is the same in financial markets, especially in private financial markets, and even more so in early-stage private financial markets. When extremely established and successful investors embrace an idea, it incentivizes other investors to follow suit in prevailing “up-rounds”, providing a windfall for the initial investors even though quite often little or nothing has substantively changed in the company itself.   

When Warren Buffett’s Berkshire Hathaway reports its new holdings, as well as positions it has trimmed, it often sparks a residual effect on the stocks themselves. If someone, often hailed as the greatest investor of all time, is buying a stock, many other investors will follow, in turn driving up the price. For instance, on November 16 of 2022, , Buffett disclosed an increased stake in Paramount Global, and the stock promptly jumped more than 5 percent.   

This same type of FOMO (Fear of Missing Out) investing is hailed as one of the causes of recent public market bubbles—both with meme stocks like GameStop and AMC, which are down ~50 percent and ~80 percent this past year respectively—and with “blue-chip” technology investments such as Canadian-based Shopify which has also seen its stock fall almost 75 percent in the past year after a meteoric rise. (As of Jan 1, 2023).  

Venture Capital   

This same principle of following the leader applies in the world of venture capital, a form of private equity that targets early-stage companies with long-term growth potential. Venture capital is generally sourced from established firms, angel investors, and other financial institutions. Leading venture capital firms include A16Z (Andreessen Horowitz), Bain Capital Ventures, Bessemer Venture Partners, Greylock and Sequoia Capital—to name a few. Each of these firms manage billions of dollars, primarily dedicated to early-stage companies.  

These firms didn’t just come out of nowhere; they built up their reputation—and in turn, their assets under management—over years of successful early-stage investing. For instance, some of Sequoia Capital’s best investments include ByteDance (TikTok’s parent company), Airbnb, DoorDash, Instacart, Stripe and Zoom. A16Z’s track record is equally outstanding, having invested early on in companies such as Instagram, Lyft, Slack, Reddit and Github.  

With track records like these, it makes sense why other investors want to invest alongside these savvy firms. Once established as industry leaders, when successful firms make investments, other firms often compete to participate in the following rounds. With typically higher valuations and shortened timespans between capital raises relative to companies in similar stages accompanying each new round, the earliest investors effectively start out with an implied premium before the race for success has really even begun.   

Diving Deeper  

In March 2021, livestream shopping platform WhatNot, a platform for collectors to buy and sell collectibles, raised a $20M Series A led by A16Z. Just two months later, in May 2021, it raised a $50M Series B led by Y Combinator (YC), and four months after that, it raised a staggering $150M Series C— cementing it at a $1.5 billion valuation. Since raising money from the likes of A16Z and YC, other investors piled in, allowing the company to raise more and more money leveraging the famed VC investors’ “stamp of approval”. Less than a year later, in July 2022, WhatNot raised $260M in Series D funding, bringing its total funding since the initial $20M Series A led by A16Z to over $460M, and its valuation up to $3.7B (a 2.5x increase from the Series C round in September 2021).  

This is not to say that WhatNot isn’t a great company that warrants major investment; it is simply noteworthy how much money it raised, how quickly it raised it, and the exponential valuations it was able to achieve in the ensuing rounds after its Series A led by A16Z.   

For these established investors, this pattern means they are able to consistently underwrite the growth of a given company at scale to result in future cash flows that will ultimately warrant a certain exit multiple deeming the ~2-3x return they are seeking for investing at such a late stage.   

A scarier example of this pattern occurred with FTX, which raised ~$210M from Sequoia Capital in its Series B—at an $18 billion valuation. Only two months later, the company was valued almost 40% higher at $25 billion, and six months later, FTX raised a $400M Series C at a staggering $32 billion valuation as investors piled in after Sequoia. To be fair, as of this point in time, it is very unclear what happened with FTX, as some investors are saying that in their diligence process, the company looked like “a healthy, growing business that provided an easy-to-use platform for people to buy, sell and store crypto.” 

As of November 11, FTX filed for Chapter 11 Bankruptcy after it was not able to keep up with its liabilities and faced a liquidity crisis. Sequoia released a letter to shareholders in which they announced they were writing the investment down to $0. However, FTX raised over $2B in its lifetime, with only $210M coming from Sequoia. Moreover, the other 80 investors that lost roughly $1.8B, some of them with equally impressive track records as Sequoia, such as Tiger Global, along with individuals witnessing this pandemonium, may become warier investing at premium valuations without adequate due diligence, even if firms like Sequoia or A16Z invested before them.   

Given that these firms primarily base their returns, other than on liquid exits (IPOs and private acquisitions), on subsequent funding rounds—are their returns inflated? It poses the question that there may be a never-ending cycle of “Respected Firm Investment”—other investors follow at a higher valuation—Respected Firm Raises more money based on these returns—Respected firm invests in other companies. Are the returns really based on material changes in the company’s operations and bottom-line growth, or are they simply based off the money following them? 

Funding Dynamics  

It is also noteworthy to touch on the dynamics of raising funds in recent economic environments.  

In 2021, founders had the “leverage” in a time where it seemed like every company was raising massive amounts of funding and VCs had huge pressures from their investors to deploy capital in a timely manner. This fear of missing out on the next Facebook or Google puts pressure on investment firms to cut corners in their due diligence. Moreover, founders were able to give VCs extremely tight deadlines, which also led to a substantial lack of diligence opportunities.   

For instance, Instanbul-based delivery company Getir was able to raise a Series B, C, and D, cumulatively totalling $983 million, in just a six-month period – moving from an $850 million valuation in its Series B to a staggering $7.5 billion valuation in its Series D. Another example of extremely quick rounds occurred with electric vehicle company Rivian, who raised three rounds and over $17 billion in 2021 alone (two private rounds and one through an IPO). Again, this is not to say Getir and Rivian are not an outstanding companies worthy of such funding; it is simply noteworthy how fast they were able to do so. However, it is also relevant to mention that Rivian’s stock is down over 85 percent since IPO.  

In 2022/23, as “real diligence” returns – referring to longer periods and inherently more in-depth research, VCs and other investment firms now have the leverage given that founders simply cannot raise a round led by the fear of missing out anymore.  

Moral of the Story   

Overall, these aforementioned venture capital firms are industry leaders for a reason—they are some of the most sophisticated and successful investors in the world. Following their investments often makes sense, and to a certain extent, they deserve the “premium” that they warrant, but when the party stops, there can be serious consequences.  

At the end of the day, it is vital that investors conduct their own due diligence to inform their investment decisions and not rely on others—no matter how established they are.  

Even Warren Buffet is wrong from time to time.