When Reddit lists on the New York Stock Exchange next week, the social media platform is expected to carry a valuation of up to $6.4bn — well down on the $10bn it was worth in 2021. It will be the first high-profile tech start-up to list since Instacart, which was valued at $10bn in its initial public offering in September, just a quarter of the eye-watering valuation placed on it by investors in 2021.
Despite the combined nearly $35bn write-off of supposed shareholder value, these “down round” IPOs are not being met with derision in Silicon Valley. Instead, they are a signal that rationality is slowly returning to venture capital.
Down round IPOs “are not only going to become common, they will become the standard for the class of 2021”, says Venky Ganesan, a partner at Menlo Ventures. He is referring to a group of late-stage companies whose valuations soared that year as investors, punch drunk on low interest rates, poured in astronomical sums. US venture investment in 2021 was a record $345bn, more than double the previous year.
Now start-ups are running out of cash and venture capital funds need to return some money to their investors. “I am encouraging all of our companies who have the financials to support going public to go public,” Ganesan adds. “Down is the new up.”
It is a sentiment that has been rippling across Silicon Valley with increasing confidence in recent weeks as technology stocks rally, partly on the booming prospects of artificial intelligence. “People who were hiding in their caves are now wandering outside and feeling good and that is palpable,” a co-founder of a large venture firm told me.
Successful new investments in AI might offset a multitude of misjudgments in the recent past. And there is a growing consensus that it is finally time for founders to swallow their pride, accept a massive haircut to valuation and help establish a new floor for their stock to start growing once more, helping to encourage all the companies coming up behind them to do the same.
Not everyone will fall into line. Stripe co-founder John Collinson told the Financial Times this week that he was “not in a rush” for an IPO of the $65bn payments group. But a few more solid companies coming to market at reset prices may help destigmatise the long-held psychological opposition to down-round financing that has become baked into Silicon Valley’s culture. Reddit’s investors have maybe had to recognise the reality that it is not a $10bn company at IPO but if the company does well, the lower valuation might become a floor for its stock price.
Still, when listings start happening in force, there will be some seriously painful consequences for later-stage investors who fuelled the 2021 start-up bubble. There are hundreds of companies that were funded in a low interest rate environment that should have been shut down or sold, but have managed to only delay the inevitable reckoning. A valuation cut might not be the worst outcome for many.
The looming crunch also highlights the cost of the herd mentality in the venture capital industry, which has become comfortably used to mostly moving en masse and in the same direction. The rush erodes discipline.
In 2021, deep-pocketed investment funds competed for ways into overpriced fledgling companies. In many cases, they signed away key protections, including those that allowed them to veto an IPO below a certain price.
Unlike a sale of a company or a liquidation, a stock market listing converts all preferred stock held by a business’s venture investors to the same common stock held by employees and management, extinguishing the various rights secured by backers over rounds of raising private funds. The drop in valuation combined with the lack of protections means late-stage investors have little recourse to prevent decisions likely to result in punishing losses.
Sequoia Capital, which invested $300mn in Instacart over its lifetime as a private company, made a paper gain of more than $1bn when it listed — but at one point that investment was worth as much as $5bn. Firms including Sequoia, T Rowe Price, Fidelity, and Andreessen Horowitz that invested a combined $265mn in Instacart in 2021 saw that investment collapse by 75 percent.
“It is becoming increasingly clear that whatever was underwritten is no longer the case,” said one venture capitalist at a firm that controls billions of dollars. If Silicon Valley is moving through the stages of grief from denial and anger to acceptance, that might be a healthy thing in the long run.
Potential Future Trends in Silicon Valley
The recent wave of “down round” IPOs and the valuation corrections seen in tech start-ups like Reddit and Instacart are indicating a shift towards rationality in the venture capital landscape. This shift signifies the end of the era of exorbitant valuations driven by investors’ excessive optimism fueled by low interest rates.
The surge in down round IPOs is expected to become the norm for the class of 2021, as start-ups face a cash crunch and venture capital funds strive to return money to their investors. This shift in perception is gradually gaining confidence in Silicon Valley, particularly with the resurgence of technology stocks supported by the prospects of artificial intelligence.
The successful investments in AI hold the potential to offset previous misjudgments and pave the way for start-ups to accept lower valuations, establishing a new foundation for growth. Founders will need to set aside pride and embrace the reality of new valuation levels to encourage other companies to follow suit.
However, not all companies will willingly accept lower valuations. Some, like Stripe and its co-founder John Collinson, may choose to delay their IPOs until optimal conditions arise. Nevertheless, more companies going public at reset prices can help challenge the prevailing stigma surrounding down-round financing in Silicon Valley, leading to a potential change in perception and greater acceptance of more realistic valuations.
As the shift towards rationality takes hold, later-stage investors who fueled the 2021 start-up bubble may face painful consequences. Many companies that secured funding in a low interest rate environment might have been shut down or sold, but instead have been prolonging an inevitable reckoning. While a valuation cut may seem unfavorable, it might serve as a necessary correction for the sustainable growth of the industry.
Furthermore, the dominance of herd mentality among venture capital firms has eroded discipline within the industry. In the pursuit of gaining access to overpriced start-ups, deep-pocketed investment funds compromised on key protections, such as veto power over IPO decisions below a certain price. This lack of safeguards leaves late-stage investors with limited recourse to prevent profound losses.
The stock market listing process adds to the challenges faced by late-stage investors, as their preferred stock converts to common stock, diluting the various rights they had secured over preceding funding rounds. Without the previous protections and diminishing valuations, these investors are left vulnerable to decisions that might result in significant losses.
For instance, Sequoia Capital’s initial $300mn investment in Instacart turned into a paper gain of over $1bn during the IPO. However, the investment had once reached a value of $5bn, highlighting the substantial decline experienced. Similar drastic valuation reductions were encountered by other firms, including T Rowe Price, Fidelity, and Andreessen Horowitz, revealing the scale of losses suffered as a consequence of the IPO frenzy in 2021.
The current acknowledgment and acceptance of the changed dynamics in the venture capital industry can be seen as a positive development in the long term. It marks a move away from denial and anger towards a more rational approach, allowing for a healthier and sustainable growth environment in Silicon Valley.
