In October, we held our annual Limited Partners meeting at NextView. In addition to reporting on the progress of our funds and the exciting stuff happening with the portfolio, we shared some thoughts on the broader market environment for VC’s and venture backed technology companies. If you tracked the headlines this past year, you would have seen what looks like a roller-coaster of activity. Below are just a handful:

NYT: “The Rise of the Unicorns” – April
Fortune: “VC’s have ‘Dying Unicorn’ lists, but they aren’t sharing them” – Sept
WSJ: Fidelity Sees Big Gains from Hot Startups – Oct
Fortune: Fidelity Marks Down Even More Popular Tech Startups – Nov

What is going on here and how do we think about what’s in store for next year? We started our discussion looking at our own market, but it turns out this is tied to VC market and broader capital markets too.

From the seed stage perspective, what we’ve seen this year is that the definition of a seed round has broadened considerably. While we continue to focus on companies that are very early, usually well before PMF, we also hear of more and more seed funds that “want to see more traction” before investing. There is greater variability in the size, valuation, and stage of companies that raise seed rounds, and often, companies raise 2 or 3 seed rounds before a series A.

This is happening because many series A investors are not really investing in early stage companies any more. In fact, many of these investors are not just looking for early product/market fit, but for meaningful scale and growth. It’s a lot of work to invest in early stage companies, and it’s easier to try to chase anything with traction and pay up for those opportunities.

Usually, the balancing force for this sort of momentum strategy is pricing and ownership. Investing in companies with scaling revenue and tons of momentum means that you are paying high prices, which then means that the investor is either putting more dollars at risk than they would be comfortable with, or living with lower average ownership across their portfolio. This is a bad thing for investor returns. Josh Kopelman put it very simply in his post here.

But, looking further downstream, the later stage funding landscape has been incredibly robust. Both late stage VCs as well as non-traditional investors are searching for growth anywhere they can find it in the capital markets. These are institutions with huge amounts of capital who are relatively price insensitive as long as they have some downside protection. These investors continued to pile on to these high-momentum companies at higher and higher prices. This has allowed the series A and B investors to get away with being undisciplined about price and ownership. In fact, they were actually rewarded for their momentum investing because these late stage investors allowed them to mark up their investments to impressive levels, even if the underlying economics of many of these businesses do not support it.  A number of investors look like geniuses temporarily.  But some of the best investors out there (example, example, example) have been very cautious, and have either slowed down their pace dramatically or looked to non-traditional markets for investment.

Our prediction in October was that this is not a sustainable situation for the early stage market. Later stage investors will eventually need liquidity for their positions, and given that the valuations of these companies are well beyond where most M&A happens, the only outlet is the public markets, and the public markets are pretty unforgiving to companies that are not exhibiting near perfect execution.

This has started to unfold. Over the last year, these late stage financing rounds have had more and more teeth. The ratchet protection put in place by the last round of investors in Square is just the tip of the iceberg, and is relatively benign relative to other structures that I suspect are out there. For a while, earlier stage investors have been able to ignore these when valuing their own positions, but I think that is not longer going to be the case.

As later stage investors start to mark down their positions or become less enthusiastic about this sort of investing, the downstream effects will be that momentum driven VC investors will get their collective hands slapped. There will be a resurgence of investors that are focused on valuation and businesses with stronger foundations (high margins, network effects, great engagement and retention, etc) even if raw scale or top line growth isn’t as eye popping. These investors will invest a bit earlier, we’ll see series A round sizes come down to more normal levels, and the the variability of institiutional seed rounds will be reduced as well.

Looking forward to 2016, my prediction is that this will all unfold, but it will move slowly at first. While some late stage investors are likely to pull back, I think there is one more cohort of international capital sources that will continue to prop up the later stage market for a time. We’re already seeing these players in later stage rounds, and I think there are more to come. But 2016 will be overall a more tempered market environment, and there will be a bit more caution overall in the venture industry as investors have to digest the rationalized valuations in their portfolios.

This may sound a bit scary, but for founders of early stage companies, I wouldn’t be too panicked about how this unfolds. I don’t see how this leads to anything catastrophic for the early stage market. If anything, it will mean that VC’s will be hunting more for great early stage opportunities and will be more thoughtful about disruptive ideas with early PMF, as opposed to just chasing growth. It’s also not hard to be optimistic about the underlying pace of growth and innovation that we are all seeing.  Although some late stage unicorn companies have been punished in the public markets, it’s still astounding to see the level of scale and growth that these companies were able to achieve. Square for example is a company that has gone from zero to $1B in revenue at astounding speed, and as my partner Lee discussed, the underlying business is very robust. The last financing round was terribly mis-priced, but that is really a very small part of the story behind a remarkable company. And there are many more remarkable companies like this that are being beat up at the moment, and many many more that are being started (or will be started) in the coming years. It’s been an interesting roller coaster ride recently, and although we may be on the other side of a local maximum, I still see the market overall going up and to the right for quite a while.