A Valuation Comeuppance

Is the seed and venture capital world about to go topsy turvy?  The roiling of the stock market has ripped the band aid off of the funding market.  Finally, we might be seeing Bill Gurley and Fred Wilson‘s cautionary words come true?  Brad Feld has noticed that angels are “tired”.

Even the WSJ has noticed.  Angel investors are pulling back.  They have slowed down.  Their volume has dropped.  It’s a world wide phenomena as India’s VC community pulls back too.

I think this is very normal and have some observations.

  •  Seed stage capital is not the same as venture capital  Semil Shah notes the differences and has his own observations about the seed stage market here.  I think the seed market is much more efficient than the Series A and beyond market because it is the first slug of capital in a company.  It can adjust faster.
  • The stock market directly affects angels.  Since the first crack in late August of 2015, angels have slowed down as a bear market hits their pocketbooks. In 2008-09, angels were not busy at all.
  • I don’t think Angel List is a proxy for the angel funding market.  It’s very coastal centric.  Valuations on the coasts far outstripped valuations in the Midwest.  I remember speaking with Mark Suster and he said $6M pre-money is the starting point for a lot of seed in Silicon Valley. At that time, a higher valuation in Chicago would have been $4M.
  • If you are an entrepreneur that initially was going to raise at X, and now investors only want to put money in at .50X, it all depends on where you are as a company.  If it’s seed, decide if you want to build it.  If you still think the opportunity is there, take the money and go.  If you are a later stage company that round might still be an up round depending on your prior valuation.  Take the money and go.  If it’s a down round, you have decisions to make.  There are a lot of variables.  Many of the decisions will be management decisions to keep valued employees around.

Here are two charts.  One shows pre-money valuations over the last three years.  I pulled it from here.  Seed has climbed higher, but the later stage valuations climbed the most.  This is the result of new later stage capital coming into the market.  It’s also the result of demand.  Because companies get acquired and fail, there are simply less later stage companies to invest in.  VCs compete strongly to get into them, and valuation is a part of that competition.

The other chart is this one I made a while back when I blogged about Snapchat. Here are some of the hot tech companies performance once they went public. I included two Chicago companies, GrubHub and Groupon even though they didn’t IPO in 2015.
BOX Chart

BOX data by YCharts

The only way to make money on these stocks was to short them. Even if you sold option premium you got crushed.  The performance of tech IPO’s is sending a chill into the market.  Seed investor Jason Calcanis thinks the market may have already corrected.

This data gives me a little fear.

People that are starting to look at this data and read about it are looking backward, not forward.  It’s always easy to see a bubble in the rear view mirror.  As a seed investor, I can set the terms on future investments and the rear view mirror data gives me negotiating leverage.

Seed funds generally have performed better than later stage funds.  The data shows it’s better to invest in emerging managers.  But, it’s incredibly difficult to raise a first fund.  Existing funds have a far easier time of it.  Will potential investors pull back from seed funds?

The later stage market isn’t as efficient as the seed stage.  That means if I am a fund that is going to raise a new fund, my performance isn’t going to look as good as it used to.  Imagine if you were in Foursquare and were carrying them at their prior valuation, $500M, and now marked them down to their current valuation, $250M.  It’s not just them.  Plenty of later stage companies that carried nice size valuations are getting marked down big time.  What will LP’s for those funds do?  Will they continue to invest in venture since it has gotten a continual bad rap over the past 15 years?

For angels and seed funds, it all depends.  If you don’t assume that 50% of your portfolio will be worthless, you are using the wrong assumptions.  For that 50%, valuations don’t matter because it’s a total loss.  There is always a power law of returns when it comes to investing.  If your portfolio is more mature, and companies have been overvalued at later stages, your paper returns are likely to take a hit.

The answer is not to pull back, but to keep networking for more deals.  It takes around 20 to start to find the 3-5 that could become the ones that make or break your portfolio.  Since all seed companies are identically and independently distributed when it comes to probability of huge success, it’s impossible to pick who will win and who will lose.

The other answer is to maintain a pretty strict discipline.  Don’t invest if the valuation is too high.  If you can’t bring yourself to walk away from a deal, don’t start negotiating in the first place.  During the negotiation, it’s important to be very transparent with the entrepreneur.  If you feel yourself getting cold feet, don’t hide why.

I remember trading through the bubble of 2001, and 2008.  Pre-crash, it was impossible to short the market.  It was impossible for rational people to buy it too. You had to pick your spots and be very careful.  I think this latest run up from 2012-August 2015 was similar.  The slide down is going to be more painful, because markets are less liquid.  Recently, I have watched as there are vacuums and big tick moves on little volume.  That adds to the fear circulating in the minds of all investors.

Money is still cheap. We are still seeing game changing innovation every day with tremendous opportunity.  The stock market is in a bear market and likely will be for all of 2016.  The Private Equity and Real Estate markets haven’t adjusted yet.  Later stage VC markets are in the adjustment process. Seed valuation adjusts faster, there is incredible value to be had there.