Risk and Investing

There is a lot of fear in the tech community over a bubble.  The last time there was a bubble, the entire stock market collapsed.  That’s not going to happen this time.  If there is a bubble and it bursts, private investors, VC funds and a lot of entrepreneurs with employees will be hurt.

Valuation is an art form, especially at early stages.  Yesterday I was talking to a couple of startups about initial valuations.  As I have said previously, corporate finance is a strategy.  It’s not just about numbers.

There are some macrotrends that are artificially pumping up startup valuations.  It’s important to know and observe those trends.  They will end at some point.  Those trends are:

  • continued cheap price of money.  The Federal Reserve policies are distorting the market
  • huge cash balances on corporate balance sheets
  • distorted incentives causing the wealthy to chase higher returns and assume more risk
  • fad of corporations getting into venture investing
  • rise of unsophisticated early stage investors
  • entrepreneurship fad among younger people

Investing in startups is all about risk versus reward.  Most startups fail.  The ones that make it need to have outsize returns to pay for all the ones that fail.  This is why an angel investor shouldn’t get excited about the $20M exit.  Yes, you got a return.  But, odds are you are in ten other deals that will be a total fail.  You need to hit some home runs to return your capital plus some.

What I have noticed lately is the startup market is looking very barbell like.  There is a lot of money going into early stage deals.  In some cases, this has pumped up valuations.  That in turn has pumped up the valuations of successful deals that are Series B or C.  After all, if a seed stage startup just raised a round at a $6M, shouldn’t my startup be worth $30M, $40M, $50M because we have product market fit and so on?

At the early stage, I think crowdfunding has pushed up valuations.  I like crowdfunding, because it can create less friction to raise capital.  I also think independent people should be able to do anything they want with money they earn.  The IRS limits wealth creation in the US via its accredited investor policy.  Crowdfunding also forces VCs and angel groups to raise their “game”.  They are under more pressure to provide value outside of capital.

At the same time, if a startup can’t get a “name” angel on their crowdfunding sandwich board of investors, they have a hard time raising money.  If they do get a “name” investor, then it seems like the herd follows that investor into the deal.  Herd following is dangerous, because you never know why people are investing and you are assuming the other person knows more than you.  The whole point of early stage investing is to find a kind of arbitrage, where the investor knows more than the market and can exploit that to their advantage.

Flip that to later stage companies.  When companies start to have success, VCs need to be in their deal for a lot of reasons.  VCs first loyalty is not to their companies, but to raising their next fund.  If they aren’t in the hot deals, they will have some explaining to do to their LPs.  At the same time, getting some money in a later round gets the name company on your list of portfolio companies, but do the investors actually make any money?

Let’s say there is a hot company. All of my numbers are made up, and I am not using any company as a template.   XYZ company uses mobile to attach people to widgets.  They crowdfunded their first round and raised $1M at a $6M valuation.   Along the way, they picked up some hot name investors, and even some hot VCs that invest early.

The company has grown from the three founders to 200 employees.  The three founders are graduates of some of the top schools in America according to US News and World Report.  Two of the founders went to top flight graduate business schools and have MBAs.  Many of their employees have equity in the company.  The founders are really wealthy on paper.  They have taken a $7M post funding company to a $3B valuation in 36 months.   They have raised over $200M in capital.  The company has a modicum of revenue.  It’s really focused on growing its user base so it can develop the widget market.  Every VC is calling them wanting a meeting.  The team feels it can raise another round of financing to grow, and potentially do an IPO.

They raise another $100M in capital at a $5B valuation.  What’s next? How do investors in the last round, or even last two rounds make any money?

There are two ways to monetize, sell to an acquirer or IPO.

If they go the acquirer route, it’s a tough sale.  How many corporations in their industry can buy them and take the dilution hit on their own cap table?  The price to purchase is going to be higher than $5B, because investors won’t want to sell there.  To realize any return, the later stage investor is going to have to sell at $10B or more.  The corporation will use more of a private equity analysis to acquire the company.  They will look at assets, expenses that they can consolidate and get rid of, and revenues-even imputing some potential new revenue streams.  They will calculate a weighted cost of capital, and then come up with a terminal value of the company.  They’ll look at their own internal opportunity costs and make a decision.

But, remember Company XYZ doesn’t have any current revenue that can support even the $3B valuation.  There might be a lot of hocus pocus dominocus in the projected numbers.

Absent a corporate buyer, Company XYZ looks to public markets.  Prior to Sarbanes-Oxley, this company might have gone public when it hit $50M in value.  The reality is the investment bankers have been chatting them up for over a year.  They want the IPO business so they can make money.  They are whispering sweet nothings in the founders ears.  They buy them lunch and dinner.  They go to ballgames.  They even say things like, “We will really support your stock once it goes public.”

Indulge me to tell a true story.  When we were interviewing investment bankers for the $CME IPO back in 2001, I asked one of them about what happens post IPO.  The banker looked at me and said, “We will support you post IPO.  We brought Company ABC public at $10, and ran the stock up to $90.”  I asked, “Where is the stock trading today?”.  The banker replied, “$10, but we all made money.”  Most investment bankers are no smarter than anyone else.  They use fancy language, went to fancy schools, but they are just salespeople.

When a company like our XYZ widget company goes public, bankers try to gin up all kinds of interest with road shows and presentations to investors.  But, Wall Street likes to see growth and especially revenue.  Does anyone think there is any chance that Company XYZ will get a valuation of even $5B when it hits the street?

Who gets hurt if the house of cards collapses?

The founders most certainly.  They might have cashed out on some stock in some of the capital rounds, but odds are they are holding a lot of it.  Their employees get hurt.  It’s likely they accepted less than market wages to work on the startup in return for equity.  Their option packages will be underwater.  The VCs that invested are going to lose money.   They got into the hot deal, but now instead of being a badge of honor they can sell, it’s a black mark they have to hide.  They better hope they have other deals that exit.

The fad of entrepreneurship will get hurt.  Kids will look at that and start to gravitate toward the certainty of corporate type jobs that have steady pay with no peaks and valleys.   Stability will mean more to them than the fear of missing out on the next big thing.

Since most corporate venture capital operations invest in later rounds, they will get hurt too.  That will cause their executive teams and boards of directors to analyze what they are doing, and likely pull back.  The corporate VC is doing nothing to help the share price and because of the general publicity on valuation collapse, they don’t want their company associated with it.

I think there is a lot of mis-pricing of risk in the marketplace today given the potential rewards.   This doesn’t mean to avoid investing-but it does mean to have extra discipline when investing.  It will mean missing some awfully good looking deals.  It also means that you better be prepared to support the deals you are in, because it might get harder to raise capital.