On December 18th, 2014, the NetForum NY held its monthly breakfast. As usual the broad diversity of the attendees' experience resulted in a fascinating discussion, meeting our promise of deep peer-to-peer learning.
This meeting's objective was to answer several questions: Are we "technically" in a Bubble? Do we "feel" like we are in a Bubble? How does a company CEO behave armed with the answers to these questions?
The data does not support the case for a Bubble. PitchBook's Ben Diamond joined us and shared some his firm's research. (Available here and here.) The PitchBook data shows that over the last 10 years, median startup valuations have increased significantly across all stages -- in particular in the Seed and D+ rounds. However, we are only (!) seeing doubling or tripling in valuations from arguably low levels in the post-Nuclear Digital Winter of the early/mid-2000's.
The PitchBook data supports what pundits have called the "barbell distribution" of venture investment. The greatest percentage increases in valuations have been in the Seed and Late stages. The Seed world in in the throes of the Angelist, Incubator and Crowdfunding effects -- the influx of capital through these platforms is raising valuations and size of rounds. Late stage rounds are affected by the decision of late stage companies to delay going public until they are quite mature, effectively forcing institutional public market investors to invest in these late stage companies when they are still private (and thus enabling these companies to delay their IPO). (The NetForum's event at the NYSE covered this phenomenon.) PitchBook's data shows that the Valuation/Revenues multiple decreased of 2014 IPOs was significantly lower than 2000 IPOs -- an indicator that we are not witnessing Bubble pricing, at least not at IPO time and by comparison to 2000...
Another distinguished guest was Lou Kerner, who runs the Social Internet Fund and recently published his views on the current state of startup valuations. (Available here.) Lou's view is that we are not in a Bubble. One of the key data Lou points to in his analysis is the percentage of the total market capitalization of the S&P 500 represented by tech companies -- it is below the historical trend, and thus negates the argument that tech is over-represented in the index due to an inflated valuation.
Generally, NetForum members were split on answering the simple question "Are we in a Bubble, yes or no?" "Pockets of Bubble" is probably the most representative answer. All agreed that it is still very hard to raise capital for any startup, except for the exceptional ones. The Series A Crunch is very real and mid/late stage Walking Deads abound. Our members working for strategic corporates indicated that valuations on divisions they are selling are robust, including for the crop of companies that sell to PE firms -- usually these are the less sexy companies with good margins and perhaps less growth than the IPO crop -- with exit multiples at 10x to 15x EBITDA, and a return of the covenant lite debt deals. Members with visibility into the venture debt market indicated that venture deal size have ballooned with $5M deal sizes becoming the norm where $1M-$2M used to be the norm.
Market sentiment seems to be one of acceleration then, not of Bubble. The feeling expressed by many was that there was a lot of activity in the market, a lot of business creation, a lot of enthusiasm in the industry and even confidence as people are willing to step out and take risks. At the same, no one would say "this time it's different." As Lou reminded us, that's what they said before the last Bubble burst -- capitalism has ebbs and flows, so there is a down after the up (I am paraphrasing.)
Our members generally agreed that the valuations of private companies in their last round does not mean those companies are worth that value. Buying preferred stock with a liquidation preference is akin to buying an option -- as long as you are sitting at the top of the stack, you will get your money back and perhaps win the lottery. (My own comment: The management team, with common stock and options, has brought in the lottery players in the cap structure. If management does not hit the jackpot, they get nothing, being at the bottom of the stack...) Today, the market is again replete with funds willing to buy options at very high prices. The options are bought on proven management teams -- successful CEOs are at a premium now with capital providers looking for proven leaders to go mine new sectors for gold. One of our members working for a public company highlighted the negative premium of public companies -- private investors are buying expensive options on private unproven businesses while public investors are judging similar companies that happen to be public based on their cash flow and usually are not forgiving...
A revealing moment came when I asked the group: "if you are the CEO, and you just heard this discussion, what is your next move?" One of our CEOs stated that he had wished to grow his business conservatively but the availability of capital exposes him to the risk that his competition will raise more money that him and that will put him at a disadvantage. I believe that the unanimous view was "take the money now." Optimism aside, everyone had the same piece of advice: take the money now as who knows when the market will turn.
From my vantage point, in this my 20th year in the tech startup business, it is distressing to me that the private venture capital market is structurally irrational. Venture investing requires a suspension of disbelief and suspension of the rules by which every one else lives -- cash flow and profit margins not eye balls, engagement metrics and traction. Those of us in NYC live side by side with Wall Streeters who look at us as if we were the spoiled kids on the block with a sense of entitlement -- we are the innovators, we deserve to get money! Sand Hill Road is an anomaly and feeds this fantasy. The flavor of the day gets funded and probably overfunded. Overfunding leads to excessive risk taking -- usually getting ahead of the market and of customer demand -- to meet irrational expectations sold by inexperienced CEOs or CEO's who are pressured to go for broke. Eventually, it blows up and the good and bad gets hurt. Is this the best way to generate innovation and to solve the problems that merit solving, meet the needs that should be met? But that will be the subject of another NetForum breakfast... :)
Thanks to all the attendees. Share your views on this Blog, join the NetForum group on LinkedIn, or write to me.
Laurent
laurent@parkviewventures.com
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(P.S. I have been asked why the meeting synopses only identify very few people by name. The events are private and our members express themselves freely knowing that everything is off the record. I summarize their views in my own words. Experts are invited to share views, research or opinions. They are mentioned by name.)
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