What is really happening?
Here’s a small sample to paint the picture:
Jeremy G. Philips, General Partner at Spark Capital, penned a New York Times op-ed titled The Rise and Fall of the Unicorn, stating the obvious, that “the unicorn descriptor was useless”, via a not so coincidentally similar title to a more analytical Economist piece from November 2005, The rise and fall of the unicorns. [So much for the rigors of the NY Times op-eds policies on titles duplications.] Brad Feld had already mused on the death of such distractive creatures in September 2015, via a post titled Unicorpses.
Last week, Josh Kopelman, Partner at First Round Capital, summarized the situation via a video response to the following question at the Upfront Summit: What has surprised you the most about how the venture capital industry has changed over the past five years? Says Josh: “The fact that the public and private markets have disconnected, and valuations of private companies are no longer expected to come to public markets realities.” Josh’s was really describing one of last year’s most vexing developments for Tech VCs,- delayed cash outs from expected returns that typically follow the lifecycle of startups. Last October, Mark Suster had already put the blame on “outsiders”, a claim that Fred Wilson wasn’t so sure about yet.
But this lack of liquidity echoed what Fred Wilson said at the same Summit in his interview with Dan Primack,- saying that entrepreneurs owe it to return money to VCs who funded them, by going public. Fred reminded us that this type of liquidity was good for all stakeholders,- employees, founders and investors. What Fred said was widely interpreted as a direct message to UBER who not only continues to raise private funds at ongoing higher valuations, but also has a super tight lock on stock liquidity, which compounds the situation.
Recently, Mark Suster wrote three successive posts where the titles say it all: Why UBER Should Go Public, followed by The Resetting of the Startup Industry, and finally What Most People Don’t Understand About How Startup Companies are Valued. Basically, Mark is saying that valuations are too high, and he backs it up with solid quantitative & qualitative assessments.
Of course, LinkedIn’s public market correction on February 5 2016 was another reality check wake-up call, but it’s also part of the overall trend of falling public valuations for SaaS companies. Fred Wilson reminded us of it in When the going gets tough, the tough get going, and Tomasz Tungunz noted that revenue multiples are now 3.3, from a high of 7.7 in January 2014 in The 57% Drop in Saas Valuations.
Albert Wenger, Partner at USV explained what he is seeing in Possible Recession and Operational Excellence in Tech, where he says that startups who are well managed and exhibit good numbers will suffer less from the declining valuations trend.
Keith Rabois of Khosla Ventures was more radical in his predictions, saying “all hell is going to break loose”, predicting even lower falls in the ranges of “25 to 75%” further down, in this short interview with Emily Chang on Bloomberg TV.
Rafat Ali, the sole notable entrepreneur voice, tweeted some sarcastic statements, not showing sympathy for VC’s.
Since VCs have treated startups as dumb pipes for returns, time founders start treating venture money for what it is: dumb money.
— Rafat Ali (@rafat) February 13, 2016
No comments, but Ouch.
It is peculiar to note that we are not hearing from the private equity investors, except indirectly from Fidelity who previously announced they marked down many of their investments, which was another way of acknowledging high valuations.
In my opinion, we should welcome a more rational investment environment where company valuations follow a naturally parallel evolution to their real progress, without super inflationary factors caused by a “keeping up with the Joneses” mentality. These Joneses are today the UBERs, Snapchat or Dropbox.
There is nothing wrong with private investors taking company valuations higher, on the way to the public markets, but only if warranted, of course. However, not every company is like Facebook or UBER. These are giants and exceptions, and we tend to under-estimate the fact that many moons had to align for them, while they continued to outperform along several dimensions. So, we can’t just extrapolate from their situations in order to deduct earlier stage valuations for all other companies, something that private investors probably got carried away with.
Along its ascent, Facebook generated plenty of newly minted, big and small millionaires who went on to create their own ways to re-invest directly in tech startups, or via new funds. That was a very good thing because the ecosystem needs to feed unto itself in order to continue growing and expanding. We are still waiting for a similar UBER wealth spill over effect to take place, and perhaps they are waiting to reach the same level of valuation that Facebook was at when they went public: $100 Billion.
Most VCs have gone through up and down cycles, and they know how to deal with these turbulent moments, but I’m more worried about entrepreneurs. For many of them, this might be their first one.
So, my advice to entrepreneurs is to be extra vigilant, realistic, and choose the right pace of growth without artificially rushing to higher valuations.
Rushing leads to crashes, disasters, corrections, disappointments, and losses. I’ve said this before: speed kills. Rushing to the public markets led to the crash of 2001, and rushing to high private valuations has led to the undesirable situation we are seeing today.
For entrepreneurs, a few items to think about:
- Know your key metrics,- the ones you will use to back-up your next funding event.
- Tighten your belts by cutting non essential work that doesn’t contribute to your metrics.
- Keep exceeding your progress metrics if you want higher than average valuations. Otherwise, you will hear something like this, “that 20M pre-money valuation we were talking about, well it’s now more like 12M.”
- If you raised an A round in the past year in the range of about $8-10M, on a pre-money valuation of $35-40M, your B round will be very challenging, unless you are blowing out your numbers.
- Stay disciplined. Despite knowing the basics of discipline, things typically derail when either investors or entrepreneurs lose that sense of discipline. And that is more likely to happen with the least experienced ones.
- Next rounds are not going to be as high as previously thought in the past few months. A “B round” that was planned for a pre-money valuation of $50-60M might get done more likely at a $30-35M valuation, depending on the specific situation.
- In bad times, the greatness of good VCs shines out. The good VCs will support you, whereas the bad ones will dump you faster than a hot potato, or might bail you out with terrible conditions like a 2-3X liquidation preference on that last down round (big ouch and a possible kiss of death or a fire sale).
This malaise might have been characterized by the discontinuity between private and public markets, and the ensuing dryness in liquidity, but as a long time observer and now participant in the tech investment ecosystem, I can’t recall a period when everyone was happy and everything was perfect. There’s always something to complain about in good and bad cycles: too much money, not enough money, too many startups, not enough engineers, high valuations, too many funds, not enough early stage capital, too many companies going public, not enough companies going public, etc. The list goes on.
Whether this is a temporary malaise, or a silent pain, the end-result will be adjustments,- mentally and quantitatively. Companies that are over-valued or under-performing will adjust, and a new (temporary) equilibrium will emerge, until the next turbulence moments.
Unlike the loud crash of 2001, this time, the ecosystem is not crashing, because it is stronger, more antifragile, and is full of real-time signals that should result in less surprises and plenty of warnings, and that gives enough amplitude for anyone to revise their mode of operations,- entrepreneurs, angel investors, VCs and hopefully private equity investors.