The investor psychology and why VCs aren’t immune

One of the most oft-repeated quotes about investing goes something like this: Be fearful when others are greedy and greedy when others are fearful.

While Warren Buffett may not have had venture capital in particular in mind when he offered up that bit of sage advice, it is a fitting way to describe the current climate of the VC industry.

Over the last year, venture capital has undergone a paradigm shift of sorts with regard to the approach investors are taking in choosing where to put their money. Instead of playing it fast and loose with capital, VCs are now taking a more conservative stance when it comes to funding, much to the chagrin of fledgling companies. When you consider what’s behind the shift, it can all be boiled down to one thing: fear.

How “fear of missing out” drives decision-making

Fear and investing are a bad mix, and history has shown time and time again what happens when emotions come into play. Take the last real estate boom, for example. As home values continued to climb, investors were scrambling to cash in — but when the market crashed, there was a mass exodus.

In the midst of the boom, there was a large volume of capital pouring into real estate, even as it was becoming clear that values were inflated and a correction was on the way. Once the bubble burst, that same capital virtually disappeared. This was a direct reflection of the fear factor at work.

Value investors, on the other hand, saw the real estate market’s impending nosedive as an opportunity to scoop up undervalued properties or capitalize on unforeseen opportunity. Think Michael Burry and The Big Short. Burry caught a lot of heat from his hedge fund investors for going against the grain and taking a short position against mortgage-backed securities because it didn’t fit with the norm. In the end, he generated billions of dollars in value from that move because he took to heart the maxim of being fearful when others are greedy.

When you look at where venture capital is right now, it’s easy to spot some similarities. Once again, it can all be traced back to an underlying sense of fear that has seeped into the market and taken hold.

Venture capital: Then and now

The venture capital industry is constantly evolving, but it has been in the last two years that we’ve seen some of the biggest changes. Venture capital funding declined in 2013, but just a year later it bounced back in a big way. According to a market analysis from TrueBridge Capital Partners, venture capital funding increased by 65 percent in 2014.

In terms of late-stage funding, 2014 set a new record, with $33.2 billion in capital being poured into these investments. At the same time, valuations for late-stage companies jumped by a jaw-dropping 107 percent, despite the fact that many of them are choosing to stay private longer. According to TrueBridge, startups are now waiting an average of eight years before going public, compared to five years a decade ago.

Deals were being funded left and right in the first half of 2015, but over the last few months, we’ve seen a virtual 180º shift, largely driven by rumblings of a correction in the tech industry. At the root of the decline in deal volume is a fear of uncertainty that’s pushing rationality right out the window — and for startups, the funding outlook isn’t nearly as rosy as it once was.

That pullback on the part of VCs is something we’ve experienced here at RealtyShares firsthand. In October of last year, we began to pursue a $30 million Series B funding round. We set $30 million as the goal because of the trends we’d seen in valuations, but, at the same time, we were conscious of this growing atmosphere of pessimism and over-cautiousness surrounding venture capital.

When we began approaching VC firms we noticed that instead of looking at hard numbers and what the positives were from an investment perspective, the focus was on what could go wrong. In some cases, investors were saying no without even taking a glance at our fundamentals.

Those early conversations threw into sharp relief certain doubts and fears that weren’t evident in the venture capital industry six months prior. To counter those fears, we decided to regroup and adjust the amount of funding we were going after. The result was a successful bid for a $20 million Series B round; if we had stuck to our initial $30 million goal, it’s entirely possible that we wouldn’t have been able to secure funding at all.

The key takeaway for startups, based on what we’ve experienced at RealtyShares, is that the old rules of VC fundraising no longer apply. Entrepreneurs who are on the hunt for capital need to know that things like valuation sensitivity and check size are luxuries that aren’t readily available to startups in the current environment. Simply put, going after a huge funding round is no longer the objective — reaching the next milestone and surviving is what matters most.

What’s happening presently with venture capital parallels what happened in real estate during the last boom and eventual bust. Investors rushed to fund startups, many of them in the tech sector, because there was an artificial sense of pressure to not miss out on the next big thing. This deal-chasing led VCs to assign inflated values to startups based on top-line growth numbers versus tangible data, such as the company’s road to profitability, unit economics and burn rate.

Overvaluation spawned a legion of “unicorns,” which are taking increasingly longer to go public. That means VCs are also waiting longer to see returned any of the money they’re investing. At this point, investors are realizing too late that they should have taken a step back, and now they’re dialing back on risk. In the meantime, startups are finding it more difficult to get funded because the venture capital pendulum has swung back on the side of extreme caution.

If VCs had taken a page out of Michael Burry’s book and moved against the tide instead of flowing with it, the current situation might look very different. Investors could have found themselves in a more profitable position; but instead of seeing their returns grow, they’re seeing worries climb over the viability of deals involving these overvalued companies.

Mapping out the road ahead

So where does venture capital go next? Despite 2015 being a record-breaking year for VCs, a slowdown in funding and deal activity is already underway. According to the 2015 Venture Pulse Report from KPMG International and CB Insights, global VC investments dropped from $38.7 billion in the third quarter to $27.2 billion in the fourth quarter. In the U.S., total VC funding came to $13.8 billion, the lowest point since Q3 of 2014.

Serious questions are being raised about the sustainability of the current valuations of the unicorns, many of which are concentrated in the tech industry. As VC firms continue to move away from that “fear of missing out” mentality and view the market through a less bullish lens, the byproduct is a closing of the capital floodgates.

Ultimately, the latest developments in venture capital are pushing the market back toward where it should be — with valuations grounded in real numbers rather than pie-in-the-sky projections. For the short term, that’s not exactly great news, but a correction lays the groundwork for investors to find some real opportunities for backing quality companies.

That brings us back to where we started, with the wise words of the Oracle of Omaha. VCs aren’t bulletproof and, just like any other investor, they’re susceptible to the same periods of craziness where the market is concerned. As we saw in housing and are now seeing with venture capital, the FOMO effect can be disastrous if left unchecked.

Going forward, the key for venture capital is being able to balance the potential for growth against the potential for loss without allowing unjustified fears to dictate investment decisions.

Bottom line, unless investors are able to rein in their irrational fears, it’s the startups and entrepreneurs behind them who are going to suffer the most as long as a lockdown on funding remains the status quo.