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Analyzing the Malaise in Tech Venture Capital: It's All About Adjustments

Adjust ImageThis past week, the number of warning-related blog posts and articles calling for a Tech venture capital correction, recession, or more bad news accelerated, and filled my Feedly and Twitter streams.

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.

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.


Why There Might Never Be Another Tech Bubble

  • Over exuberance and hype about the Internet’s capabilities – just reading media articles in 2000 would demonstrate that.
  • Over abundance of venture capital commitments – close to $100 Billion were poured in 2000 alone.
  • Less experienced VCs running funds – some large funds were hiring a lot of new VCs with little experience.
  • Valuations were getting higher, and companies were fixing them based on others that preceded them – unfortunately, the minute you start doing that, the system self-inflates itself, and undoing the damage becomes problematic.
  • Deals that shouldn’t have been funded were being funded – the gold rush mentality was real, and crazy ideas received funding with big amounts.
  • Companies went public prematurely – they did that before proving the business model’s viability, and some of them even before generating significant revenues.
  • Lots of consumers were buying stocks in public Internet companies – it was the trendy thing to do, as there was a fear of missing out, and a belief that the sky was the limit. Sadly, while investors could take losses, consumers couldn’t, and many of them suffered subsequently.
  •   So, in 2000, there were plenty of excesses and bad practices to go around, from venture capitalists, entrepreneurs, public markets and consumers alike. Today, the picture is very different, and we are not even close to a bubble. Why do I think so? It’s a combination of two factors. One, the tech ecosystem is a lot more resilient than in 2000. Two, we’re not seeing the same bad symptoms of 1999.


    I’ve previously written about the resiliency of the tech startup ecosystem (or we should say Antifragility), in the context of reviewing the book Antifragile by Nassim Taleb in a 2013 post, Good News, The Tech Startup Ecosystem is Antifragile. Specifically: 1) We’re more resilient about taking losses. Not only is it cheaper to start a company; but if you fail, you fall from lower heights, so it won’t hurt as much. “Small” failures are not harmful to the system as a whole. They are only harmful to the small teams being affected. 2) We know a lot more about running Internet companies. Today, there are many more lessons from mature and successful Internet companies. We have learned a lot about how to succeed as a startup or Internet company. Failures and successes have made everybody smarter. That body of knowledge is benefiting the whole, and it keeps getting better. We are producing better startups, and better entrepreneurs. 3) Entrepreneurs are better networked. Social networks and social media had their effects on the entire tech community, and this is a good thing. Business accelerates when its network participants are connected without barriers or distance challenges. 4) There is a better quality of accelerators. Techstars, Y Combinator and other top tier accelerators didn’t exist then, at least not at the quality and caliber levels that we have today. 5) Ecosystems around the world are becoming viable and vibrant on their own turf. New York, Boulder-Denver, Austin, Seattle, Berlin, London, Waterloo-Toronto, just to name a few are strong stand-alone ecosystems, with their own full set of actors.

    Not like 1999

    A lot is different today, when compared to 1999. It is important to understand these differences and their implications. 1) The tech startup ecosystem is more international. Unlike in 1999, today, risks are spread outside of Silicon Valley. The likelihood of a domino effect of failures that is concentrated in one area is unlikely. 2) Investors are wiser and tighter with their funding. Despite the recent flurry in new fund announcements, we still haven’t reached the capital commitments levels of 2000 by any stretch. See the following NVCA historical chart, from their 2014 Annual Yearbook report: Screen Shot 2014-08-31 at 12.58.46 AM 3) Going public isn’t the main goal. Yes, tech IPOs are returning, but they are returning timidly, and with the lessons of 1999 still engraved on everyone’s minds, i.e. these companies are going public with sustainable revenues and/or profits. In parallel, a number of healthy exits are happening to counter-balance the need for an IPO. 4) Crowdfunding is a release valve for demand. A lot more startups can get funded via non-traditional ways, thanks to open marketplaces like AngelList, CircleUp and others. Independent investors and agile angel investors are offering another sifting mechanism for helping startups succeed.

    How to spot the next bubble?

    If we were to see the following symptoms re-appear, there would be cause for concern:
    • Good companies abound, but they can’t get funded
    • Companies that shouldn’t get funded start to get easily funded
    • “Me too” companies get funded in order to compete based on greed
    • Many people with no Internet experience start to get into tech startups or VC
    • We start to see big failures from companies that were funded with a lot of money
    What about overvaluations? I think that’s OK, because they equalize over the long term, most typically at the subsequent round. If a company got funded at a high price, two things can happen. Either they live up to their expectations, and they earn that valuation over time, or they don’t deliver and they take a haircut at the next round, if there is one. Either way, things end-up by equalizing. What if the new VC funds end-up producing lower returns? Well, I think that would hurt these VCs (and their LPs) more than entrepreneurs, but as long as the top VCs continue to perform well, LPs will keep returning for them. In closing, I’m not going to categorically say there will “never ever” be a bubble in the future. But I will say at least, that the signs aren’t apparent, now. If a bubble were to happen, it will likely be from a new set of causes that aren’t that visible or obvious today, or it could be from a black swan type of event. At least for now, we shouldn’t fear another Tech Bubble, but rather let’s embrace the great times we’re in, with the wisdom of the past, and the optimism of the future.]]>

    VC's as Analysts and Farmer’s Market Shoppers

    Screen Shot 2014-05-28 at 7.46.00 AMI’ve been listening to a lot of product and company pitches in the past few weeks, as part of building my funnel of startups to potentially invest in. And I noticed two VC role analogies: 1) the VC as an Analyst, and 2) the VC as someone at a farmer’s market.

    The VC as an Analyst

    I was a technology analyst at Aberdeen Group during a six month-stint in 2005. Part of the sauce process was to take a lot of briefings from vendors, and to talk to an equal number of customers that were using their products or having that need. The end result gave us unique insights and a more complete picture of what was going on in that sector. Then we were able to write the “analyst report” as brilliant synthesis of what was out there, backed with quantitative data and qualitative observations. It made us look smart and in the know, but that’s really how that game was played. Another part of that job was to then talk to customers, and because you had heard all the vendor pitches, you were able to suggest some advice for them. The VC-Entrepreneur relationship often starts with a pitch, a deck, a slide, a series of emails, or a discussion. And after hearing the story, you start to slot it in your mind somewhere. Your analytical skills come into play, and since you have heard a number of similar or related pitches, the picture gets clearer and clearer. Then you add your pattern matching to this, and you start to hone in on the deals that you like to continue pursuing, and ones that you have to pass on. But in essence, you are being an analyst for your own purposes. Some VCs blog about that and that’s a good thing. Many of Tomasz Tunguz’s posts are very much like analyst posts, and if you didn’t know he was a VC, you might think he was an industry analyst.

    Just Like at the Farmer’s Market

    Another part of the VC’s job is to cherry pick the deals they want to get into it. And that’s no different than going from one stand to another at a Farmer’s market. But you don’t want to make your choices too early before you have seen all the available stands. Everything looks great initially, but there is always something better around the corner, and if you’ve already purchased the first apples you saw, you might see a better apple stand a few minutes later, and you might regret that quick decision. That was basically Chef George Zakarian’s advice in this article Don’t Buy Anything For The First Half Hour at a Farmer’s Market:
    First things first: Don’t buy anything for the first half-hour. See what you see. Ask for samples of everything. Then sit down for a minute and have a coffee and write down what you’re going to buy. Don’t be manic — everybody buys way too much. They get excited, they buy this and then say: “Why did I do that? This chocolate looks better, but I just bought this chocolate!”
    That said, it doesn’t mean that everything you pick has to be perfect. Sometimes you pick tomatoes that don’t look great, but they are ripe and fragrant, and that’s what exactly you needed for your sauce recipe, but sometimes you want the look and shape to be perfect too, because you’re presenting the produce a different way, and it has to stand on its own. The analogy is that VCs continuously see startups that aren’t “perfect”, but that have a lot of good parts in them, and they choose to fund them and work with them, in order to help making them better.

    Take-away for Entrepreneurs

    As an entrepreneur, you want to do your homework and make it easy for the VC to understand where you fit in the space or trend you’re playing in. As an analyst, pitches that were clearer than others were more memorable, and sometimes material from them was used in the analyst report. Be the pitch and team that is memorable by being original and authentic about what you are doing. A good VC has probably seen a lot of pitches and teams like yours, so they can see through the cracks if you try to hide them conspicuously. Recognize that VCs are going to compare you to others in your space or outside of it. Just like you might be shopping for VCs, they are shopping for you. Decisions aren’t often made after the first stand stop. The passage of time will reveal a lot about people in the same way that some produce ripen to perfection, and others don’t.]]>

    AngelList as the Modern Stock Exchange and Rome of Venture Capital

    AngelList’s role in the metamorphosis of the venture capital business. I think they are the new Rome of tech startup venture capital, because “all roads lead to it”. Whether you are a startup raising or planning to raise money, or a venture capitalist looking to invest in startups, you probably won’t complete your next transaction without some discussion at least, about whether AngelList is part of it or not. I was first introduced to AngelList in December 2011 by Fred Wilson, as he gave us his first investment commitment for Engagio. He introduced me to Naval Ravikant, who asked me to register on AngelList to get the process going.

    66 Things That Make a Great Venture Capitalist

    VC imageWhen we ask what makes a great Venture Capitalist, we should look at the answer from the entrepreneur’s perspective, because I have not met a VC who was successful by not backing great entrepreneurs. Of course, VCs have their own internal metrics of success (e.g. IRR or Cash-on-Cash), but these are outcomes of having worked with, and backed great entrepreneurs. There is no other way to getting returns on money invested.

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