2017 will be a strong year for venture capital

What does my crystal ball say about the outlook for venture capital in 2017? The building blocks of a better year are in place. Many venture capital firms are flush with cash, startup valuations have become more reasonable, technology industry M&A is robust and the technology IPO market is improving. Moreover, the obsession of funding unicorns at almost any price — and at the expense of smaller startups — has materially waned. All good news.

Most important, venture capital has a good chance of returning, at least in part, to its fundamental roots in the new year. While investors have been infusing unusually huge sums in some of the biggest startups ever, venture historically has been about targeting promising companies early in their formation and betting they have the potential to soar. As an early-stage investor, Menlo has found that these deals have always offered the best potential returns.

Overall, 2017 will be better than 2016, but 2016 wasn’t bad. Funding in early-stage startups declined, valuations fell — in some cases sharply — and the technology IPO market was weak until the very end, undermining prospects for startup exits. Nonetheless, company funding overall was strong and good venture firms had no problem raising new funds. Because venture firms have stockpiled money, they’re well-positioned to take another look at early-stage deals, now very reasonably priced, and once again invest in them liberally.

In hindsight, 2016 turned out to be a year of rebuilding. VC investing was very robust in the first half of 2015, but then declined both quarters in the second half of 2015 before essentially bottoming in the first quarter of 2016 at about $12 billion. VC investments exceeded $15 billion in the second quarter and largely stayed there in the third quarter, according to PricewaterhouseCoopers and the National Venture Capital Association.

What attracted a lot of media attention last year was the fact that the growth of unicorns — or venture-backed companies valued at at least $1 billion — continued a marked slowdown that started in the last quarter of 2015. Only nine companies that quarter became unicorns, down from 23 in the preceding two quarters. The trend continued in 2016. Nonetheless, top unicorns, such as Uber (Disclosure: a Menlo Ventures portfolio company) and Snapchat, continued to attract all the money they needed, whittling funds available for smaller startups.

A weak IPO market exacerbated the trend. Wall Street lost its appetite for technology IPOs and the best unicorns saw no need to go public as long as ample private funds at generous valuations were readily available. Just 17 percent of companies surveyed in a 2016 Silicon Valley Bank study said their goal was an IPO. The first 2016 IPO by a U.S. venture-backed technology company — Twilio, a cloud communications platform-as-a-service company — didn’t occur until June, and it raised more money than anticipated, which was a surprising, but excellent outcome. Today, the IPO market is strengthening — five successful technology IPOs have been added to the board since Twilio.

Looking ahead, the biggest reason for optimism in the venture capital landscape is that venture firms aren’t hurting for cash. Buoyed by some billion-dollar-plus funds, 134 venture firms closed funds totaling $22.5 billion in the first half of 2016 alone, a record-setting pace, according to PitchBook.

In addition, the Internet of Things (Iot) and big data analytics are driving a record number of merger and acquisition (M&A) deals, including Microsoft’s $26 billion acquisition of LinkedIn and Symantec’s nearly $5 billion acquisition of privately held Blue Coat Systems this year. M&A, of course, is a major exit path for startups. Technology M&A could be even bigger in 2017 because of more reasonable startup evaluations and a growing tendency among major companies to expand their horizons by buying smaller companies outside their traditional lines of business. That’s why software behemoth Microsoft purchased social network LinkedIn.

Then, too, there is the surging stock market and, by extension, the rebound in technology IPOs. This has been fueled not only by a strengthening economy but by President-elect Donald Trump’s intention to bolster the economy further by reducing taxes, streamlining regulations and sparking major infrastructure development. A Republican-controlled Congress is highly likely to support the measures he proposes.

In such an environment, there is every reason to expect that non-traditional startup investors, such as mutual funds, hedge funds and sovereign wealth funds, will continue to invest in private technology companies.

Lastly, there is the distinct possibility that venture funds will resuscitate their traditional passion for early-stage investing. This usually pays off more because investors receive a bigger ownership stake and are an integral part of the startup team. According to Cambridge Associates, a research firm that studies the financial reports of venture firms, early-stage investments have accounted for the bulk of the venture industry’s gains since 1994.

I’m often asked how I view 2017. Bottom line, I’m optimistic. Given the facts, there is no reason not to be.