Venture capital: It's not all gloom and doom in 2016

2015 will go down in start-up history as one of the most active, colorful, and well deserving of its own Hollywood movie starring unicorns dancing in the cloud surrounded by bubbles with lots of gold at the end of the rainbow.

In 2015, we saw wearable technology reach the next level, online lending and marketplaces take center stage, and virtual reality come out of the shadows to give us a peek into the future. Acquisitions heated up in almost every sector to make 2015 the biggest M&A year ever —from online education (acquisition of by LinkedIn) to the enterprise (acquisition of EMC by Dell).

Crystal ball predictions
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As I predicted last year, online education continued to gain momentum. A record $1.6 billion of investment was poured into education technology across 161 companies in just the first half of 2015. On the other hand, Internet of Things software platforms and services didn't own the spotlight as I thought they would; it was IoT hardware, led by Fitbit's IPO, which continued to drive headlines.

So far, 2016 has been volatile and it seems all we hear in the media is gloom and doom. However, I think it is very important to avoid panic and to take a thoughtful look at the long-term fundamentals of technology innovation to truly predict what we will see for the rest of 2016 and beyond. This year, we'll still hear the familiar words: cloud, marketplaces and virtual reality, but I expect these sectors to take new shape as late stage investors' increase their focus on revenue, growth and a path to profits. 2016 will be the year we will see late stage and public investors flee to quality companies and take fewer risks on unicorns with no business models.

1. A shrinking unicorn population. The list of unicorns, start-ups with valuations $1 billion or more, continued to grow in 2015, but 2016 will bring these companies into a new light, which won't be as flattering. Many unicorns will continue to stay private and seek out new capital infusion from investors. However, financings will become much more challenging and founders and CEOs who seek the unicorn bragging rights will find themselves getting onerous financing terms like ratchets, participating preferred, and aggressive liquidation preferences. Some will get down rounds and some might not make it at all.

I predict the list of unicorns will shrink and that remaining list will be populated by network effect businesses with revenue, growth, and even profits. Historically, network effect businesses have generated the majority of the gains in venture capital, especially around consumer tech, and 2016 will be the year when VC's realize that history will repeat itself. The stronger the network effect, the stronger the company's position will be in the market. As Michael Moritz said, "you cannot defy gravity."

Aggregate valuations among this stable of unicorns will actually grow but wealth will be much more concentrated among the few who prove that they have a durable business. The unicorns that will continue to thrive are those that have strong backing, great leadership, are customer-obsessed, and most importantly, prove their revenue model and path to future profits —think Airbnb, Uber and Palantir.

2. IPO market window stays ajar (for a lucky handful). While 2015 delivered the worst IPO year for VC-backed companies since 2010 and there's a lot of talk that the IPO market will continue to deteriorate further in 2016, I do expect the IPO market to remain somewhat open, but incredibly selective. Tech companies with strong financials in particular will be a key driver of momentum later this year — think Airbnb.

As we've already seen this year, the U.S. market is off to a slow start, so betting on companies with tried and true business models and high profit margins will remain of utmost importance for investors. Additionally, as China continues to face challenges in its own market, particularly around lack of transparency and deflation, I predict more Chinese investors will refocus their attention to the U.S. market — and therefore, fuel capital to the U.S. technology sector.

3. Virtual and augmented reality is real. 2015 was an exciting year for virtual reality in terms of early use cases in selected fields, but in 2016, we'll see it go beyond entertainment and make a much bigger impact in other large sectors. The NFL, the United Nations, and the Air Force are already using virtual reality as part of their training systems and we'll see this trend continue into education, defense, sports, enterprise productivity, and retail. For example, Tommy Hilfiger recently became the first major retailer to offer its shoppers a virtual shopping trip.

With big names like Oculus finally shipping their headsets in March and Sony with Project Morpheus, virtual reality will become more than just an immersive, cool technology, but one providing another important layer to our daily lives.

4. eSports: Let the games begin. The international eSports market has shifted from niche to mainstream in Asia, but it still seems to be in the early stages around the majority of the world. According to research firm Newzoo, about 205 million people watched or played eSports in 2014 (primarily in Asia) and the space is continuing to grow about 21 percent per year. The worldwide market for eSports is valued at $612 million in worldwide revenues, with North America contributing $143 million. As an example of its growth among consumers, ESPN recently launched its own eSports vertical to keep consumers up-to-date on the competitions.

However, the market is currently dominated by China and Korea. In 2016, we'll see the U.S. take a bigger leap into this market, perhaps with a broader set of titles that appeal to a wider set of the global population — multi-player arena games, and first person shooter games will continue to lead the way into eSports. Amazon's 2014 acquisition of Twitch will also turn out to be genius and the company will enable and popularize the category. Once the U.S. consumer gets a hold of this new addictive form of entertainment, eSports will truly takeoff.

5. Education: 2016's Sector of the Year Award. The global education market has reached $4.4 trillion, and more than ever it's proving to be a key sector for prosperity, jobs and overall growth — its importance is further represented from it being a No. 1 topic of the 2016 presidential election. In 2016, I expect consumer spending on education to continue to thrive, and we'll see at least 2-3 new worthy unicorns emerge. Pluralsight, Udacity, and Udemy are a few strong companies with a real chance of immense success in the public markets. I still think we are only entering the bottom of the 1st inning of edtech, so this and marketplaces are some of the key areas I am most excited about long-term.

Overall, I think 2016 will be an exciting year when investors fly to quality, new categories emerge (virtual reality & eSports) and a couple established categories will dominate center stage (edtech and marketplaces). Buckle up!

Commentary by Sergio Monsalve, a partner at Norwest Venture Partners, focusing on early stage investments in marketplaces, mobile applications, on-demand applications, consumer finance, and educational technologies. His current investments and board seats include Adaptive Insights, Gemvara, Motif Investing, Rafter, SketchDeck, Udemy, and ZIRX. He holds an MBA from Harvard Business School and a BS in management sciences & engineering (industrial engineering) from Stanford University. Follow him on Twitter @VCSerge.

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