The Tech Valuation Bubble Means Venture Capital Needs a New Approach: Investor

Startup investors' focus on the digital world has resulted in a gold rush for far too long, with too many venture capital firms chasing the same software companies and driving up valuations that are no longer sustainable.

Since the emergence of the internet in the 1990s and the irrational exuberance of the dot-com bubble, venture capital in America has moved away from hardware companies aimed at changing our physical world to software companies creating a new digital world—a trend that will continue with the onset of machine learning and artificial intelligence. This shift to digital, however, has come with great costs to our physical world that put our nation’s future at risk.

First, we have off-shored the manufacturing of physical products to other nations, resulting in systemic job loss and a national security issue that is high on everyone’s mind with global conflicts happening seemingly everywhere today. This shift away from building things has also irreparably harmed our nation’s capacity to innovate long-term and compete on the world stage. This is because manufacturing is an essential ingredient in building innovative physical products that can change the world, as seen in the last industrial revolution that brought us planes, automobiles, telephones and many other tech breakthroughs in science and engineering—not software.

Second, there is a new generation of hardware companies struggling to find the venture capital needed to grow. These are the companies driving a new industrial revolution in America and the world with breakthrough intellectual property that will bring sustainable and circular manufacturing into virtually any industry. Despite the importance of these hardware companies to our nation’s future, venture capital is hard-pressed to invest in them. And, when they do, it comes at a high cost.

Demands for equity ownership in a hardware company are especially high early on when traditional valuation methodologies only recognize the value of a venture based on multiples of early revenues and ignore the scalable IP asset value that would better align with the higher capital requirements of hardware. This heavy equity dilution is further compounded by multiple financing rounds inherent in a venture capital investment model, disheartening entrepreneurs who must devote many years of their lives to changing our physical world for the better.

The digital focus has resulted in a gold rush of sorts for far too long, with too many venture capital firms chasing the same software companies and driving up valuations that are no longer sustainable. With rising interest rates, valuations have sobered up, putting a chilling effect on the IPO market and investor returns. Not only have higher interest rates increased the discount rate used in valuations, but they make it more expensive for companies to borrow money, impacting their profitability.

Despite seeing the writing on the wall in the news every day shouting out that it’s time for a change in a digital-first venture capital approach, VCs have continued their aggressive hunt for software companies with unicorn potential to the exclusion of hardware companies. And the pandemic accelerated this digital transformation through software, leading to even more emphasis on software companies and further leading to an irrational exuberance in valuation.

With too much money chasing software companies, paper valuations skyrocketed in venture-backed financing rounds until recently, and in many cases without a clear justification in terms of revenue or profitability, creating another valuation bubble reminiscent of the dot-com era. The result was many companies gaining stratospheric valuations on mere promises of what the future would hold rather than tangible results.

A new investment approach

Traditionally, company valuations were based on metrics like price-to-earnings ratios, tangible assets and predictable revenue streams. But today’s software darlings of the VC world often lack profits and instead focus on growth, network effects and potential future earnings—all enabled by low-cost debt rather than breakthrough IP. Metrics like monthly active users (MAUs) have become as crucial as bottom-line figures in venture capital valuations.

While this forward-looking approach has its merits, especially in sectors with strong network effects, it’s also fraught with risk. Predicting the future is always uncertain, and many startups fail to live up to their lofty expectations. This can leave investors holding the bag when reality doesn’t meet the promise, as we see in today’s IPO market. 

Thus, a new investment model is needed for hardware companies with game-changing products. Investors should look at these companies as IP properties and value them in two ways, not one: 1) the old-fashioned way as a new venture and 2) the modern way as a scalable IP asset—an IP property—that has the potential of creating many new ventures.

In this IP focused valuation approach, the startup looks to grow through joint ventures and partnerships with companies that have already built the infrastructure for their business but need access to breakthrough IP to change their economics. A win-win for all stakeholders.

For investors, they see lower risk with multiple cash flow streams from many ventures that they can share in, turning a venture investment into a cash-flowing property investment. For entrepreneurs, the higher valuation afforded by including the scalable IP asset value of the business means they get to own and control their company, giving up much less equity in the business than in a traditional venture capital investment.

The current state of VC, valuation and the IPO market reflects that the broader dynamism and innovation of the American economy have weakened, calling the need for a new investment model focused on growing hardware companies and changing our physical world. While it’s uncertain where these sectors are headed, one thing is clear: we are witnessing a fascinating period in the history of finance and entrepreneurship that continues to ignore investments in the physical world, with VCs falling far from their roots. How it unfolds will shape the business narratives of the next decade and beyond.

Robert Cote is an intellectual property lawyer and the founder of Cote Capital, a firm investing in startups with a focus on innovative IPs.