Valuations in The Midwest

Posted by Jeff Carter
on December 14th, 2012

A lot of folks think there is a bubble in valuation when it comes to start ups. In certain cases, there is a strong case to be made for a “bubble”. But in many other cases, it just doesn’t ring true.

Farm road in Champaign County, Illinois (Photo credit: Wikipedia)

For example, if you look at gross valuations of companies getting funded, they are certainly higher today than they were three to four years ago. It seems like companies with less traction, and mere ideas can attract investment. Those sorts of observances would lead one to believe there is a bubble.

But, if we look at some other facts on the ground, they argue against a bubble. For example, the value of money has certainly been cheapened by the Federal Reserve over the past three years. QE forever has affected more than just the stock market and treasury market. The rate of inflation is estimated at 7.8% from 2009-2012. Because of the way they measure inflation, that may be understated. Additionally, there have been huge changes in the regulatory environment. Those changing incentives have started a trickle of money from public markets to private ones. More people are chasing the better deals, driving up prices.

Recently, some state governments have initiated angel tax credits. Those credits have also attracted new capital that wouldn’t have been in the game. Fresh capital that hasn’t been down the learning curve of angel investing can drive start up valuations higher.

For example, in Chicago back in 2009, there were relatively few places to go if you wanted organized seed round investing. Now there are at least five. Not including the unaffiliated independent investors that are harder to snare.

A new twist, money is starting to find its way to the midwest from the coasts. Traditionally, coastal start ups always had higher valuations than the midwest. Part of that could be attributed to asymmetric information. Part of it is the deal flow was always better on the coasts than it was in the midwest. Today, information flows more freely. Things like Angellist let investors know about companies raising seed round capital. If you are a west coast investor and determine that one company on the west coast with a higher valuation has the same risk/reward as a company in the midwest engaged in the same business, which do you put your money in?

Valuation is an art form. It’s partly a market clearing price of supply/demand. Entrepreneurs that seek higher valuations and price themselves for perfection better earn it upon execution of their business plan. Slipping up will cause them to fail because existing investors won’t re-up, and new investors will be looking at a down round. Entrepreneurs that use corporate finance as a strategy for growth might find themselves better off taking a slightly lower valuation knowing full well that there will be many bumps and bruises to come once they launch. Because there is higher interest in early stage investing, more people are participating and that participation is also putting upward pressure on price.

Investing in companies is a lot like trading in some respects. There is always another trade if you missed the last one. The market never sleeps. Same with start ups. It might take awhile, but you will find another gem in the rough. In 2007, I saw the start up of several companies I was unable to make an investment in. Two have been highly successful. The rest aren’t here anymore. In 2013, I suspect I will find the same ratio.

Some very experienced investors like Marc Andreessen are saying the failed ideas of the past were “just too soon”, and now may have a home in the new technological era. It’s possible. I know some people that lost money on ideas that were way too soon. Much of failure boils down to poor execution though. Only time will tell. The probability of one company having success versus another company isn’t that much different. It comes down to jockeys, not horses. We have better jockeys in the midwest now than we have had before, and good jockeys get higher prices than first time ones.

The important thing for investors is to recognize risk/reward, and also to maintain their discipline. If they don’t, they will chase deals and drive valuations even higher. Right now, I am seeing some chase deals. They are investing in companies at some lofty valuations. When those kinds of companies fail, it’s quite an eye opener. Better to keep your powder dry. Patience will be rewarded. You might miss some great deals and kick yourself later on, but the odds are with you if you invest intelligently and stay away from the herd rather than follow it.

Grr-edited. I originally put Alan Andreessen in the post, not Marc. Alan Andreesson was a market research professor of mine at UIUC, and now is at Georgetown.

Of course, as soon as I posted this, a company was sold for $176 million two days after launching…….There is more to the story. But, exits like this embolden investors and entrepreneurs.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.