Wall Street Isn’t As Excited As We Are Part 1: Down-Rounds and Contracting Valuations on the Horizon

Bullish Private Markets and an Unwelcoming Public Market

I apologize for the time lag between posts; I will be producing regularly this year. Similar to the last series of posts, this begins a new discussion on the outlook for valuations and IPOs in 2016. This first post discusses the disequilibrium between overinflated private market valuations unreciprocated by the public market. In the following post, I will discuss implications for valuations and fundraising in 2016.

In the past few years, we have noticed extreme growth in tech valuations within the private market. High valuations, often based on distant projections and unproven business models, indicate that private investors expect an equally enthused and responsive market, but this was not the case for 2015’s tech IPOs.

Sluggish 2015 IPO Performance

2015 had a respectable number of IPOs–169, tech and otherwise, in fact–but they only netted a low volume of capital: $30B in aggregate value on U.S. exchanges. This is in contrast with 2014 which produced the greatest number of IPOs (273) since 2000 (406 IPOs). 2015 produced the lowest number since 2009 following the Great Recession in 2008, according to Business Insider Australia (data from Renaissance Capital).

Here is BI’s graph demonstrating the disparity between the number of IPOs in 2015 and their volume/value in US billions:

image

Specifically within tech, the article articulates several of the “highest-profile initial public offerings have performed poorly–Box, Etsy, and Fitbit are all below their IPO prices, although there are standouts like GoDaddy.” Fitbit was considered an IPO winner, raising the largest VC-backed IPO of the year with a significant opening day price pop at $30.40. However, it hasn’t performed well in the long run and yesterday closed at $18.87, below its IPO price.

Here is a table of a few prominent 2015 tech IPOs with updated prices as of yesterday’s close (1/14/16). Etsy, Box, and Fitbit (slightly) are performing below their IPO price. Etsy’s price recently took a plunge, reaching its lowest price as its lockup period for 21.9 million shares ended on Monday the 11th.

Company IPO Price Opening Pop Close Price (1/14/16)
Fitbit (6/18/15) $20 $30.40 $18.87
Etsy (4/16/15) $16 $30.00 $7.07
Square (11/16/15) $9 $11.20 $10.82
Box (1/5/15) $14 $23.23 $10.71

Underwriters valued Square at $9 per share upon IPO, corresponding to a market value of $2.95B, just less than half Square’s Series E financing valuation of $6.03B. As of Tuesday, January 2016’s close, Square had a market cap of $3.99B, up from IPO, but still below the Series E valuation (Source: PitchBook Data). While Square is young–thus, volatile–could this “down-round” be a harbinger of a continued trend in 2016?

Your answer will depend on where you are in the investment chain. Bullish investors could view IPO “down-rounds” as discount opportunities (to new investors) that will grow in the long-run similar to Facebook. It’s true most companies offering IPO are still in the revenue-growth stage. For example, bullish investors argue that while Square faces growing competition from Paypal, Alphabet, and Apple, it has only reached a fraction of its addressable market. Bearish investors, however, might look at other companies such as Box that have been in the public market for longer. Box, which also faced an IPO down-round ($1.7B IPO to $2.4B Series F, Source: Pitchbook Data), is now trading well below its IPO price more than a year after its debut.

Maybe these examples are outliers. However, the companies above are only a snapshot of 2015s IPOs. Overall, the average IPO return has decreased dramatically over the past years, from 40% in 2013 to 21% return in 2014, to negative 5% return in 2015 (Source: Renaissance Capital). Renaissance Capital’s IPO ETF (IPO), a bundle of 60 of the most recent IPOs, fell 9% in 2015, below the S&P 500.  

Do public investors value our companies as highly as we do?

Is there disequilibrium between the public market and inflated private market valuations, as indicated by previous down-rounds and public market performance?

According to Bloomberg Business, the largest unicorn, Uber, is now valued higher than 80% of the companies in the S&P 500. Valued at $62.5B, Uber will have to IPO at a market cap of $86.25B, to match Facebook’s 1.38X multiple ($104.2B at IPO to $75B on its previous valuation). Facebook was the second largest IPO in history; the largest was Visa. Does the public market feel the same way as the private market in terms of this valuation? While it’s difficult to compare the companies precisely without Uber’s financials, a similar thought exercise could be applied to any of the unicorns, and the same question asked. Nevertheless, 2015’s lagging IPOs and mediocre company performances indicate, yes, there is a disequilibrium between the two markets.

What Caused This?

Opaque, Nonstandardized Private Metrics vs. Requisite, Transparent Public Metrics

So, if you’ve made it this far, you’re probably wondering, if there is in fact a disequilibrium, what’s the cause? The root of the cause is an incongruity between private market valuations and public market valuations. This is an intrinsic result–and accepted risk by venture investors–of lacking standardization, regulation, and quantification of private companies financial and growth metrics compared to their public market counterparts. It’s not entirely the fault of venture investors, but the nature of the venture game. How can you accurately value a company that has yet to produce revenue or determine its business model? For example, large components of Snapchat’s valuation history are illiquid indicators such as user retention, engagement, and growth. Investors believe these will convert in the future to significant and reliable returns once Snapchat secures its business model. Only recently, with actual revenue numbers, can the investors more accurately assess their Snapchat.  

Even when there is revenue or net income for a private company, investors vary widely in determining which public market comparables or industry multiples to set these numbers against to determine a valuation. Investors in the same round can vary widely–sometimes by orders of magnitude–in these determinations. It is up to the lead investor to convince everyone else their valuation is justified.

Because of lacking standards, unreliable or nonexistent financials, and only general methodologies, the lead investor often gets the benefit of the doubt. Even when the lead investor of AirBnB, for example, provides a $24B valuation based not on 2015s EBITDA but an 8X multiple (8-9X are current M&A multiples) on AirBnB’s projected EBITDA in five years when it will equal the current EBITDA of the chosen market comparable, Priceline ($3B at the time of the article’s publication). In this particular example, it’s comforting to know the lead investor of AirBnB’s $1.58B Series E round is General Atlantic, an early stage investor in Priceline, so they may understand growth potential in travel startups better than other investors. A projection out five years might seem even more plausible when you consider AirBnB is growing 3X as fast as Priceline right now, or that it has overcome recent regulation concerns, or that it has enormous opportunities for expansion. But how do you translate these phantom variables into EBITDA, debt-equity, price-to-earnings, price-to-book, or any of the other tangible metrics used for valuation in the public market? Even if, as a potential private investor in AirBnB, you developed a new valuation, what would make it more plausible and accurate?

In addition to this root difference between the markets, the disequilibrium is becoming only more evident as tech companies continue to perform poorly in the public. Other factors include the intrinsic size disparity between markets, infectious high valuation fear, and public market corrections.

Concluding Thoughts:

So What Now? Down Rounds, Valuation Contraction and Searching for a Winner

It is a sensitive time for the private market with many companies waiting for another to take the first step into the unpredictable public arena. Meanwhile, private investors hold their breath and withhold their investment dollars, hoping for a winner. I think the IPO outlook for 2016 could tilt either way, depending on whether we see winners first out of the gate, or losers.

One thing is certain: we will see a number of IPOs this year, some of them unicorns. They will be pushed out by difficulty fundraising further at progressively greater valuations and investors seeking liquidity. Due to 2015s performance, it is likely we will see more down-round IPOs to incentivize buy-in from cautious public market investors. Down-rounds will not only affect IPOs, but the private market as well as valuations contract across the entire market. Today, unicorn-hopeful, Foursquare, announced a down-round in its latest-round of financing. They raised $45M in a new round at “roughly half of the approximately $650 million that it was valued at in its last round in 2013.” This is in addition to recent mark-downs of Snapchat and Dropbox. (Source: New York Times)

Update: Jawbone just raised a new round of $165M from Kuwait Investment Authority, dropping their valuation to $1.5B, half of its $3B valuation in 2014. The last time Jawbone was valued at $1.5B was in 2011.  (Source: re/code)

The metamorphosis of a company from an opaque, private entity into a transparent, publicly accountable organization is analogous to the high school valedictorian transitioning into a college (or perhaps, moving from college into the workforce). High school performance may indicate future success–along with a few standards such as the SAT–but previous success is only roughly correlated with future success when considering the vastly different environments, their standards, and the growing number of entities to whom the student is now accountable. There is similar incongruity between the private and public markets at this time, a result of the differences in complexity, transparency, and degrees of accountability standard for each market type.

The bubble isn’t going to collapse. I don’t believe there is even a “dot-com”-esque bubble susceptible for collapse. Bullish, risk-on investors will continue to contribute to inflated valuations while bearish, risk-off investors are going to begin asking harder questions regarding valuations and investor protections. But, expect the proportion between the two investors to shift as the private market corrects itself to bring its values in line with the public market. For tech this means a slow-down: valuations will contract as investors become more risk averse, seek liquidity, and have difficulty themselves in raising future funds. This could lead to a cascade of effects–which I will cover in my next post–on IPO outcomes, secondary market froth, public perception of tech companies, investor mentality, and startup fundraising.

 

Silicon Valley Wildfires: The Effects of an Entrepreneur Arms Race

What are Burn Rates?
A few readers of my previous post expressed interest in learning more about burn rates and how startups are handling the large investment rounds they are raising. The term ‘burn rate’ refers to the rate at which a company deploys capital in a period of time. High burn rates are an inevitable side effect of investor and entrepreneur competition in Silicon Valley. Competition results in escalating cycles of investing and capital burning. This post investigates what startups are spending money on and the wider economic effects of increased spending, including the ecosystem’s influence on real estate prices.

Unicorns Aren’t As Rare as You Think
According the Wall Street Journal, at the beginning of March 2014, there were 49 VC-backed ‘unicorn’ companies valued at $1B or more. As of March 2015, there were 78 (Fig 1). In 2000, there were only 10 (Fig 2).

UnicornsMar14
Figure 1A. 49 Startups valued north of $1B as of March 2014
UnicornsMar15
Figure 1B. In just one year, the number of total unicorn companies has increased by 60% from 49 companies to 79 companies. “The Billion Dollar Startup Club.” WSJ (http://graphics.wsj.com/billion-dollar-club/).

This growth seems unlikely to slow down as venture becomes an increasingly attractive investment class compared to alternatives. Asset managers including hedge funds, mutual funds, limited partners, corporations, and sovereign wealth entities have begun pooling capital into the venture capital asset class. As mentioned in my previous posts, the growing pool of capital contributes to high valuations. Individuals within the investing ecosystem have sounded the alarm on the increasing frequency of high valuations, reminiscent of the dot-com collapse in 2000 (Fig 2).

Figure 2. Many fear the parabolic rise in unicorn valuations will eventually end with a substantial collapse reminiscent of the dot-com bubble that took place from 1999-2001. "Mega-startups go parabolic. Flame-out already happening." Wolf Street (http://wolfstreet.com/2014/10/09/priming-the-startup-scene-and-ipo-market-for-burnout/)
Figure 2. Many fear the parabolic rise in unicorn valuations will eventually end with a substantial collapse reminiscent of the dot-com bubble that took place from 1999-2001. “Mega-startups go parabolic. Flame-out already happening.” Wolf Street (http://wolfstreet.com/2014/10/09/priming-the-startup-scene-and-ipo-market-for-burnout/)

A strange, self-reinforcing paradox has taken over the entrepreneurial culture of San Francisco. As corporate investors offer high valuations to outcompete traditional venture firms, so too are entrepreneurs encouraged to spend large amounts in order to scale their product and teams quicker than competing startups. For venture investors such as Bill Gurley, the paradox lies in the challenge of investing enough capital in a startup for it to remain competitive while at the same time tempering valuations in order to control burn rates and receive a significant return multiple for limited partners. This results in a situation where, as Bill Gurley points out, there is a long list of investors ready to hand well-funded startups even more money than they actually need.

Burn Rates: What are Startups Spending On?
To put burn rates into perspective:

Bill Gurley writes in the WSJ’s Venture Capitalist Sounds Alarm on Startup Investing, “One, the average burn rate at the average venture-backed company in Silicon Valley is at an all-time high since ’99 and maybe in many industries higher than in ’99. And two, more humans in Silicon Valley are working for money-losing companies than have been in 15 years, and that’s a form of discounted risk. In ’01 or ’09, you just wouldn’t go take a job at a company that’s burning $4 million a month. Today everyone does it without thinking.”

Startups aren’t just spending this money on lean business practices and necessary resources. High valuations in tandem with high financing rounds gives startups padding to indulge in non-product/sales expenditures.

According to the WSJ’s piece, Free Spending by Startups Stir Memories of Dot-Com Era Excesses, “Startups feel the need to outspend on recruiting, marketing and designing their offices, echoing poor choices made 15 years ago when unprofitable companies overextended themselves, then crumbled when the market turned.” In order to attract and retain talent, startups are forced to offer competitive salaries, which have risen steadily since 2011 (Fig 3). These salaries are on top of perks including free catered lunches, retreats, and customized work spaces all purposed to entice recruits away from technology giants such as Google and Apple.

Figure 3. Salaries have increased steadily since 2011, corresponding to the increase in tech valuations during the same time interval. "Free Spending by Startups Stir Memories of Dot-Com Era Excesses." (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)
Figure 3. Salaries have increased steadily since 2011, corresponding to the increase in tech valuations during the same time interval. “Free Spending by Startups Stir Memories of Dot-Com Era Excesses.” (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)

Increased Spending Increases Real Estate Prices
The most extravagant startup expense, however, is on real estate. San Francisco real estate agent, Jeffrey Moeller describes “‘A four-person startup will tell me, ‘We need a 10,000-square-foot office for future growth,'” he explains. “I’ll say, ‘No, you need 1,000 square feet.'”

In 2014, WolfStreet reported on Bloodhound, a mobile application for events, that blew 2.5 times as much rent as the previous tenant because it had the investment padding to do so ($31,700/mo from $13,000/mo). That’s $375K/year on rent. The conclusion was that the founders did not care much about expenses because profits were not on the horizon. When the startup ran out of money, the owners were evicted from the space which went back on the market for $37,500/mo. The startup had raised a $4.5M Series A round from Silicon Valley investors including 500 Startups, Rothenberg Ventures, and Peter Thiel’s Founders Fund.

Another notable example is online retail website, Fab.com, which raised $150M at a $1B valuation and burned through $14M/month, spending $250K/month just on rent in New York.  The company ultimately laid off many of its employees and pivoted into Hem, which now spends $125K/year on rent in Berlin.

The side effect of salary increases and overall spending by both employees and startups is a consequent increase in real estate prices (Fig 4). This is in part due to the multiplier effect, which posits that the sale of one space impacts the price of 60 others. The influx of capital has resulted in articles such as this Huffington Post piece, entitled America’s Most Expensive City Just Got More Expensive,” reporting the median rent of a one-bedroom apartment reaching a record high of $3,410/month. The article goes on to describe how the city is becoming increasingly unaffordable for its low and middle-income denizens as an influx of wealth floods the city:

Income inequality in San Francisco is so great that it’s on par with that of developing nations, the city’s Human Services Agency found last summer, and demand for affordable housing is so unmanageable in San Francisco that the city was just able to reopen its public housing waitlist last month for the first time in four years.”

Figure 7. Price per square foot has increased in the last decade. Does the shape of this graph remind you of any other figure in this post? Hint: See Figure 1. "Free Spending by Startups Stir Memories of Dot-Com Era Excesses." (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)
Figure 4. Price per square foot has increased in the last decade. Does the shape of this graph remind you of any other figure in this post? Hint: See Figure 1. “Free Spending by Startups Stir Memories of Dot-Com Era Excesses.” (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)
Who wouldn't love to work here? By the way, their food and assortment of desserts are excellent.
DropBox’s New Office Lease: Who wouldn’t love to work here? By the way, their food and assortment of desserts are excellent. (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853).

High Valuations, High Burn Rates Discourage Lean Business Practices
The lack of transparency makes it difficult to gauge exactly how pronounced and widespread these spending habits are within the startup ecosystem. But high rounds of financing certainly don’t encourage efficient business practices.

Several investors including Bill Gurley have drawn an analogy between a company’s fitness and natural selection. I would like to expand on that idea further. A company’s development can be likened to evolution, where an idea evolves into a prototype and viable product through subsequent, hopefully several, rounds of natural selection that eliminate unviable iterations and direct the company towards achieving product-market fit, market share and IPO or acquisition.

Selecting events could include competing companies or technologies and/or the availability of limited resources needed for growth, namely investment capital.

The abundance of resources determines the maximum population size of a species, just as the abundance of funding  determines the maximum population of startups. The upper limit at which a population stabilizes due to limited resources is known as the carrying capacity. With the influx of capital via new investors and increased investor appetite, there are more resources critical for startup survival. This is equivalent to an upward shift in the carrying capacity of a species (Fig 5).

Figure 5. The critical resource for startups is funding capital. The increase in funding across the entire ecosystem allows a larger population to survive. My graph is based on the concept of carrying capacity for a biological species. As more funding pours into the ecosystem, the carrying capacity shifts upward (marked by the dotted and solid red lines), and the maximum population size increases from P1 to P2. Read more about carrying capacity here: Wikipedia: Carrying Capacity.
Figure 5. The critical resource for startups is funding capital. The increase in funding across the entire ecosystem allows a larger population to survive. My graph is based on the concept of carrying capacity for a biological species. As more funding pours into the ecosystem, the carrying capacity shifts upward (marked by the dotted and solid red lines), and the maximum population size increases from P1 to P2. Read more about carrying capacity here: Wikipedia: Carrying Capacity.

This also means the threshold for natural selection through increased financing has been lowered, allowing previously unviable startups the ability to secure funding and proliferate, simply because there is more funding to be invested. Bill Gurley warns this results in a lower average fitness for companies, writing “‘Excessive amounts of capital lead to a lower average fitness because fitness from a business standpoint, has to be cash-flow profitability or the ability to generate cash flow.'”

The increase in potential startup population is good from the perspective that it allows a wider variety of startups to proliferate. However, this wider range includes previously unviable startups that would likely not survive without the capital influx. These startups lack sustainable business models, but are kept alive by increased capital. When the maturation of a company can take 5 to 7 years before investors reap liquidity through IPOs and acquisitions, the notion of positive cash flows can seem illusory and distant for founders. In fact, specialized debt vehicles and secondary shareholder marketplaces encourage companies to stay private longer, further relieving pressure for management teams to yield returns.

Pressure on CEOs Lifted: Delayed IPOs and the Private Stock Market
The timeline to IPO has been lengthening according to CB insights, from 70 months in 2007 to 80 months in 2013 (Fig 6).

Figure 6. The average time to exit has increased significantly between 2007 and 2013. The timeline to IPO has been on the upward trend while the timeline to M&A has decreased over the past few years. "It's Definitely a Marathon--Venture-Backed Tech IPOs Take Seven Years from First Financing." (https://www.cbinsights.com/blog/venture-capital-exit-timeframe-tech/).
Figure 6. The average time to exit has increased significantly between 2007 and 2013. The timeline to IPO has been on the upward trend while the timeline to M&A has decreased over the past few years. “It’s Definitely a Marathon–Venture-Backed Tech IPOs Take Seven Years from First Financing.” (https://www.cbinsights.com/blog/venture-capital-exit-timeframe-tech/).

Why is the timeline toward IPO increasing? This is due in part to increased regulations making IPOs more difficult (Sarbanes-Oxley Act of 2002) and the JOBS Act of 2012 which makes it easier for companies to stay private. The JOBS Act allows companies to increase the shareholders from 500 to 2,000 while exempting employee shareholders who can liquefy their vested shares as part of their compensation. Private stock market exchanges including SecondMarket have arisen to handle these secondary share transactions with company clients averaging 7 years in age, $950M in valuations, and $150M in raised capital.

Beyond secondary share marketplaces, asset management firms such as JP Morgan have created a new debt vehicle called an SPL (“Stay Private Longer”) allowing prominent startups such as Survey Monkey and Jawbone to delay IPO. Disclaimer: We are secondary shareholders in Jawbone.

Andreessen’s Scott Kupor confirms in the WSJ, “More and more of the appreciations of these companies will happen in the private markets…It has become increasingly unattractive for a company to be a small-cap public stock.” Jyoti Bansal, CEO of AppDynamics writes in the same article that “he doesn’t feel pressure from early investors to cash out in part because they expect the value of his company to keep growing. ‘No one is interested in liquidity’ Mr. Bansal said, adding that as long as revenue is increasing, his investors are fine with waiting.” However, history has demonstrated that the longer these companies stay private in the hopes of outclassing previous prominent IPOs, the greater the risk of fizzling in the public markets upon IPO. Zynga, the largest IPO since Google at the time debuted at $10/share at IPO, down from $14/share pre-IPO. In five months, the valuation decreased from $20B pre-IPO to $8.9B post. If the only way to reach higher valuations is to keep these companies private, does that mean these companies are being overvalued initially?

Delaying IPO can benefit companies in the short-term, but delays can prove stressful for venture capital investors who require liquid returns in time with their own fund maturity timelines. Each delayed year results in a decreased annual return on investment for venture investors (Fig 7). Despite Mr. Bansal’s remarks, increasing revenues do not necessarily indicate profitability, and when $1B+ valued companies are still running in the red, investors are left with no choice but to prolong exits, hoping the business will eventually be able to turn a profit.

Fig. 5 Annual return on investment decreases as the number of years to exit increases for 10X and 30X return multiples. The minimum VC return is ~20% per year. "Venture Capital Exit Times." (http://www.angelblog.net/Venture_Capital_Exit_Times.html)
Figure 7. Annual return on investment decreases as the number of years to exit increases for 10X and 30X return multiples. The minimum VC return is ~20% per year. “Venture Capital Exit Times.” (http://www.angelblog.net/Venture_Capital_Exit_Times.html)

Scrappy and Successful: It’s Possible
Young entrepreneurs do not remember the dot-com bust and ride the wave of startup enthusiasm without necessary caution or wisdom. I certainly don’t remember the dot-com bust–I was still in elementary school.

Startups should be focusing on achieving market fit as soon as possible. Yet many of them are distracted by the competitive environment which results from high financing and an overabundance of competing startups also funded on high valuations.

As these startups mimic the vibrancy and warmth of their corporate analogues, are they calculating the revenue gained from each of these extra expenditures? How does an investment in retreats and swag purchases translate to improved company culture and greater work efficiency? Can that be quantified or justified during the nascent stages of a company’s development?  While Bay Area companies are known for their vast open work spaces, chic décor, and company paraphernalia, early startup founders need to accurately weigh the cost-benefit ratio of owning property in expensive areas such as San Francisco. Many are simply spending too much.

There are ways to be thrifty and successful, as many startups have demonstrated. These companies often bootstrap their way through the early stages, sleeping and working in the same room like the Verbling and Pixlee founders while living off ramen and 24-hour Fitness showers.

Forbes offers some advice on lean–and perhaps less drastic–business practices. This includes:

  • Prioritizing tools which save hours every week
  • Outsourcing CFO, HR, or Accounting services
  • Saving large expenses for a great lawyer and in-house web development.

Can you Smell the Smoke?
VCs are sounding the alarm yet still investing in high valuation and high burn rate companies. In the competitive investing climate, it is unreasonable for investors to sit back and pass on attractive investments because of high valuations and burn rates. As Fred Wilson puts it, “our portfolio is not immune to it.” Our portfolio is not immune to it. Neither is yours. Most investors’ portfolios are not immune. Valuations are not caused by any particular individual, investor or entrepreneur, but a cultural mindset and economic conditions that are socially escalating and self-reinforcing.

You can’t afford to sit out, but at the same time, you want to be careful with the money you are investing. VCs, Angels and entrepreneurs, are not doing enough to control burn rates. Increased capital has allowed for the proliferation of unviable startups and increased timelines to IPO have decreased the pressure on CEOs to achieve business sustainability. It is imperative that entrepreneurs and investors alike begin discussing the wider problem of high valuations and burn rates and their effects on the economy as a whole.

For investors, they need to be wary of increased investor appetite and the effect of increased capital on valuations and high rounds of financing. High valuations, especially with no standard across investment groups, are an unreliable indication of future venture returns. Instead, they should be looking more closely at portfolio companies achieving particular business development milestones before subsequent rounds of financing.

For entrepreneurs, they need to be sensitive of the balance between developing a company culture and attractive work place with financial responsibilities to their investors and the families of their employees. When employees join a startup, they are taking a bet on the vision and operational capability of the management team. No one wants to work for a startup that can’t achieve profitability, and that should be the priority for any CEO: creating a business. Furthermore, I think it would behoove entrepreneurs to increase transparency when it comes to expenditures outside of direct company development and marketing/sales. Although not always required in the term sheet, having an open dialogue with investors can benefit both parties in regulating burn rates.

This dialogue is important. Otherwise, if nothing changes and if the unicorns begin to fall, investors will become more risk-sensitive, venture capital financing will top off, and companies unable to find a sustainable business model after years of searching will end up desiccating and withering away. The unfortunate side effect of this will be a decline in interest for entrepreneurship and scrappy innovation that we’ve come to revere and aspire towards. I certainly don’t want that. Do you?

Part 2: The Hunt for Unicorn Doppelgangers, Corporate VCs, and Non-Standard Valuation Practices

In the previous post, I describe the hunt for unicorn doppelgängers: an investment process involving selection and valuation of startups based on comparable predecessors that have paved the way regarding product-market fit and associated performance-based valuation metrics (i.e., traction, app downloads, etc.). This is a natural, herd inclination of investors who want to invest in hot investment sectors that have proven returns and therefore present lower risk. In this post, I will describe how corporate VCs and non-standard valuation methodologies influence the valuation process.

The Rise of Corporate VCs
The problem of high-financing rounds and valuations is exacerbated by the relatively low cost of capital and growing number of active investors. With increased public awareness of technology and innovation, more wealthy individuals are becoming angels, more angel investors are becoming institutional investors, and more corporations of are dipping their hands into everything. These companies include household names such as Intel, Siemer, Unilever, Google, and 7-Eleven.

According to Pitchbook Research, the number of corporate VC deals has doubled in the past 5 years, from 432 in 2009 to 888 in 2014 (Fig 1). This trend is unlikely to slow, with the value of exits doubling “from 2012 ($15 billion) to 2014 ($31 billion).”

Corporate VC Deals
Fig 1. Corporate VC investment deals have been on the rise since 2005, doubling between 2009 and 2014. “Corporations are VCs, Too.” Pitchbook (http://blog.pitchbook.com/corporations-are-vcs-too/).

Corporate VCs have several advantages over traditional VCs in terms of their extensive industry relationships and resources, as well as vast capital reserves. These advantages position them as ideal strategic partners for entrepreneurs who stand to benefit from affiliated brand-name recognition and much-needed expertise, connections, and R&D resources.

Corporate VCs pull from extensive capital reserves that outstrip the majority of traditional VC investors, giving them a competitive advantage in attracting and securing investment opportunities. Competition with traditional VCs can drive up valuations. This can benefit entrepreneurs who seek high financing rounds, but also opens them to the possibility of corporate investors owning a large percentage of the startup company. A large percentage ownership can lead to corporate VCs demanding board participation rights and may affect the future trajectory, including management, organization and product decisions of the company. Entrepreneurs should always be careful when negotiating with big money. To more fully understand the process of valuations from both the perspectives of investors and entrepreneurs, I recommend picking up Term Sheets and Valuations by Alex Wilmerding.

Non-Standard Valuation Methods
The concept of widely varying valuations between investors depends on the lack of standardization in valuation methodologies. As every venture capital book or seasoned investor will tell you, “Valuations are more of an art than a science.” How can you gauge the future potential of a company promising innovation when they are pre-revenue and still developing their product? So many questions remain: Does the management team have the ability to execute? What is the growth month-over-month? What is the cost of duplicating the company? Is there even a market for this product? What is the competitive advantage?

Despite the sea of nuanced questions, various methodologies have been developed to bucket these questions into qualitative and non-qualitative metrics. The problem with these methodologies is, even when they offer quantitative comparisons, each method boils down to subjective judgment, even if it involves investors choosing the discount rate (which has a surprising volatile effect on valuation) in a probability-adjusted net present value calculation. These more numerical methods can also involve comparing the target company to available price multiples (i.e. P/E, EV/EBITDA) from publicly traded companies.

Other methods, such as the Scorecard method, are more subjective. The Scorecard assigns weight to abstract qualities of a startup including strength of the management team and the strength of the product and technology. These percentage weights are then summed and multiplied by known valuations of pre-revenue companies within the same sector.

Below shows a sample spreadsheet demonstrating the Venture Capital method which takes into account after-tax earnings and the desired Return on Investment (Fig 2).

Venture Capital Method
Fig 2. The Venture Capital method is a common method used by venture capitalists who expect an exit between 3 and 7 years. “How to Put a Value on Your Startup.” SoMN SourceLink (http://www.somnsourcelink.com/resources/blog/blog/2014/03/04/how-to-put-a-value-on-your-startup).

Without reliable quantitative metrics, investors combine multiple methods to reach reasonable valuations that take into account both hard and soft factors. Several funds have even developed unique methodologies particular to an investment sector.  Overall, it is up to the investor to choose a methodology that best suits the target company and financial risk.

The lack of standardization creates a black hole of mystery surrounding the valuation process, with arbitrarily different valuations offered by different investors. Some services, including Worthworm, have developed their own comprehensive system facilitating transparent valuation generation between entrepreneurs and investors. Perhaps, as Silicon Valley and other startup hubs become increasingly wary of inflated valuation, services such as these will form the groundwork of consistent, intelligent and informed valuations.

Increasing Valuations Lead to Increasing Burn Rates
High financing rounds result in increased burn rates, the rate at which startup companies use resources to grow or retain talent. Venture capitalists, Fred Wilson from Union Square Ventures and Bill Gurley from Benchmark Capital, have called attention to the problem of increased burn rates (Fig 3). High financing rounds discourages founders from employing capital-efficient strategies in running their business and consequently present a large risk for investors.

Fig 3. Relative to later financing rounds, Series A burn rates have increased at a more rapid pace since 2012. Series A generally bears greater risk than subsequent rounds.  ”Silicon Valley Venture Survey - Third Quarter 2014" (https://www.fenwick.com/Publications/Pages/Silicon-Valley-Venture-Survey-Third-Quarter-2014.aspx).
Fig 3. Relative to later financing rounds, Series A burn rates have increased at a more rapid pace since 2012. Series A generally bears greater risk than subsequent rounds. ”Silicon Valley Venture Survey – Third Quarter 2014″ (https://www.fenwick.com/Publications/Pages/Silicon-Valley-Venture-Survey-Third-Quarter-2014.aspx).

Fred states in his post, “Burn, Baby, Burn,” that “Valuations can be fixed. You can do a down round, or three or four flat ones, until you get the price right.”

A down round is when a company faces a lower valuation at a subsequent round of financing than the valuation received in the previous round. An example might be a startup receiving a valuation of $8M in the Seed round, only to receive a valuation of $7M in Series A. A flat round would be the same valuation in two subsequent rounds. A down round results in dilution of ownership and is often interpreted as a red flag for investors, who regularly report their track record to limited partners that invest in the fund. A down round can indicate eventual failure for the startup venture; companies that experience down-rounds may have a difficult time in raising future interest and financing.

High valuations, however, increase the likelihood of a down-round, due to higher, corresponding expectations for value creation from the time of the initial round to the following round. For this reason, high valuations present risk to both entrepreneurs and venture capital investors, increasing the potential of a subsequent down-round.

While down rounds and flat rounds are viable solutions for the problem of increased burn rates, they are reactive and costly to both entrepreneurs and investors who lack full-ratchet provisions (provisions which prevent dilution of ownership in the event of a down round). Despite Mr. Wilson’s solution, according to Mattermark, more than a few VC firms are complicit in enabling burn rates through subsequent rounds of high valuations and financings. Could an investor’s fear of a down-round on their track record discourage more accurate valuations? Without a standard, it is difficult to determine to what degree one investor’s methodology is better than another’s guesswork and optimism.

So Are We in a Bubble?
Despite the concerns surrounding high valuation and financing rounds, I would be wary to call our present situation in Silicon Valley, a “Bubble 2.0,” which implies a significant and widespread economic upset. Capital is at a low-cost, and the demand on both sides of investing is still high. Innovation and investment are hitting all sectors, with no sign of interest slowing down. With more people becoming entrepreneurs, and everyone else becoming investors, I believe competition and a few high-profile failures will settle valuations to an appropriate point without requiring a market collapse. Standardization will help too, if anyone can figure that out.

Part 1: The Hunt for Unicorn Doppelgangers, Corporate VCs, and Non-Standard Valuation Practices

This is a two-part post series reasoning the causes for high startup valuations within the tech industry.

If you’ve been following the tech ecosystem in recent years, you’re no stranger to recently minted startups announcing multi-billion dollar valuations (Fig 1). Dubbed “unicorns,” these industry-upending companies include the likes of Uber, Snapchat, and AirBnB. To put things into perspective, in September 2014 Uber announced a $40B valuation, when only months earlier it received a valuation of $17B from various well-known venture funds. Snapchat, infamously declining a $3B deal from Facebook,  has exploded in growth as well, receiving another $485.6M in funding with a valuation of $10B+ at the close of 2014. Each investment in a high-potential company represents a financial Holy Grail for venture investors. Even sector and industry-focused firms reserve a portion of investment capital for identifying and investing in these promising companies early in their life cycle.

In addition to a growing roster of unicorns, many technology companies are raising multiple hundred-million-dollar valuations pre-IPO. Some pundits believe the recent bevy of inflated valuations indicates a growing tech bubble on the verge of collapse reminiscent of the dot-com crash in the early 2000s.

 "2015: Tech IPO Pipeline Report." CB Insights https://www.cbinsights.com/tech-ipo-pipeline
Fig 1. Nearly a 3-fold increase in $1B+ valuation companies from 2013 to 2014 YTD. “2015: Tech IPO Pipeline Report.” CB Insights. https://www.cbinsights.com/tech-ipo-pipeline

What factors are contributing to increased valuations?

I believe there are three primary factors contributing to the spiral of inflated valuations and will cover the first factor in Part 1 of this post series.

1. Following the Leader:  A Herd Mentality – Snapchat was valued at billions before receiving a cent of revenue. Only since November 2014 has it unveiled plans to offer mobile payments via Square and multimedia advertisements. Most of its value can be derived from scalable architecture and rapid, unprecedented user traction and engagement. Combined with positive press, high retention, and effective word-of-mouth syndication among young demographics, Snapchat’s proliferation seemed guaranteed even without a traditional business model. The consequence of this is a surplus of consumer-oriented social applications attempting to mimic Snapchat’s success. This includes competition from well-known entities including Facebook which developed its own ephemeral messaging app, Poke. By the time Poke was released, however, Snapchat had already established a loyal user base (Fig 2). Facebook subsequently abandoned development of Poke and began work on their latest competitor, Slingshot.

Snapchat mentions 'skyrocket' following Poke's release. "Data Shows Online Buzz About Snapchat Is Skyrocketing After The Launch Of Facebook Poke." TechCrunch. http://techcrunch.com/2012/12/28/data-shows-online-buzz-about-snapchat-is-skyrocketing-after-the-launch-of-facebook-poke/
Fig 2. Snapchat mindshare ‘skyrocket’ following Poke’s release. “Data Shows Online Buzz About Snapchat Is Skyrocketing After The Launch Of Facebook Poke.” TechCrunch. http://techcrunch.com/2012/12/28/data-shows-online-buzz-about-snapchat-is-skyrocketing-after-the-launch-of-facebook-poke/

Parallels can similarly be drawn between unicorns and their direct competitors within other industries, including the battle between car ride services Uber and Lyft. Even in a congested competitive landscape, smaller startups such as Gett continue to vie for an ever diminishing portion of the market. While Facebook has cash to burn on experimenting with new applications, venture pockets are not as deep. Startup saturation creates the illusion of a larger market need and thus higher and higher competing valuations and burn rates to maintain a competitive edge.

Nevertheless, many investors are attracted to unicorn doppelgangers, companies they hope will demonstrate similar user growth rates and mindshare presence as previous billion-dollar companies. Riding in the wake of juggernaut predecessors including Snapchat, many of these startups continue to receive financial validation as long as they demonstrate some combination of sufficient user metrics, top-tier investors, or all-star founding teams. Little research, however, correlates these factors definitively with industry-disrupting success and abundant financial returns. Amidst the search for these ingredients, where is the product and the innovation?

Many of these problems seem to affect consumer-oriented startups that rely on overnight customer adoption and syndication. The technical and financial barriers to entry are low for aspiring entrepreneurs. The cost of user acquisition is oftentimes nonexistent. Why not build the next WhatsApp or Snapchat? But do we need another chat application? Is there truly enough value to warrant high-risk valuations in applications reliant on fluctuating user bases, especially when a substantial fraction of apps are only opened once ever? At a certain point, humans have limited mental bandwidth and attention (Fig 3). Everything is fighting for their attention: Netflix subscriptions, transportation, computers, tablets, Kindles, and multiple social media accounts, each of which must be checked daily.

Tapstream mobile analytics compared new user retention in various mobile applications from 2013 to 2014.  "Mobile retention benchmarks for 2014 vs 2013 show a 50% drop in D1 retention (Guest post)" @andrewChen.  http://andrewchen.co/mobile-retention-benchmarks-for-2014-vs-2013-show-a-50-drop-in-d1-retention-guest-post/
Fig 3. Tapstream mobile analytics compared new user retention in various mobile applications from 2013 to 2014. “Mobile retention benchmarks for 2014 vs 2013 show a 50% drop in D1 retention (Guest post)” @andrewChen. http://andrewchen.co/mobile-retention-benchmarks-for-2014-vs-2013-show-a-50-drop-in-d1-retention-guest-post/

This past fall, I had the opportunity to attend TechCrunch Disrupt, one of Silicon Valley’s most publicized startup competitions. Walking through the aisles of startups, I saw entrepreneurs pitching new chat applications, mobile game dashboards, and company tracking software. One European entrepreneur quickly took a photo of my face with his iPhone and demonstrated how his facial mapping software would allow me to apply a series of realistic morphs to my face in real-time. I was amazed by the precise geometric mapping of my facial features, a capability I wasn’t aware the iPhone possessed. I asked what the use applications were going to be. The CEO smiled and said he hoped to get it approved by Apple so they could add the morphs as an add-on to the camera filters. His long-term vision was to eventually integrate with a monolith chat application such as Snapchat or WhatsApp. “But what about facial recognition?” What about the multi-billion dollar opportunity and need for this technology in the healthcare, security, and civil service industries? Apple seems to have already recognized this value, acquiring Israeli firm, PrimeSense, and filing a patent in 2013 for iPhone facial recognition capability.

Smartphone penetration is rapidly reaching market saturation in developed economies and word-of-mouth expansion continues to validate a few technology leaders. It therefore seems worthy to consider diminishing returns and a diminishing number of IPOs for new consumer startups as established incumbent leaders become further entrenched. Recognizing this pattern, some high-profile investors have become more critical regarding investments in unproven consumer startups reliant on tenuous business models. They have begun to shift early-stage focus toward enterprise startups, postponing investments in consumer companies for later rounds when the business trajectory is more certain.