This is not a bubble, but a venture capital industry demanding high risk startups and investments. Saying that the “startup and VC industry” (whatever that is) is “in the middle of the next bubble” is like saying that all auto mechanics will willfully sabotage you car, all banking activities during the real estate bust were fraudulent, and all Americans are fat. Especially accusing larger VCs of “creating a bubble” is ridiculous, given the lessons-learned during the .com crisis and how VCs got burned across the market. Most VCs I know don’t have the illusion that “maybe this time I’m lucky and I don’t crash again”.
A bubble for me is investment frenzy of the majority of players with neither technical nor financial due diligence. I’ve seen many early-stage investments on AngelList where some people invested because one of the better known angels invested: “so why meet the team or do a due diligence if this guy vetted for it?”. Dumb. But besides AngelList I’ve seen significantly more early-stage investments that had very thorough due diligence done, and definitely meetings with the founders.
So how about the IPO frenzy from Groupon and LinkedIn? I think LinkedIn is far over-valued (See Sean Williams http://www.fool.com/investing/high-growth/2011/05/20/heres-why-linkedin-will-never-see-120-again.aspx or Courtney Boyd Myers http://thenextweb.com/industry/2011/05/19/in-the-biggest-ipo-since-google-linkedin-now-trading-at-520-times-its-2010-net-income/). Mark Hulbert did the math (http://www.marketwatch.com/story/linkedin-investors-need-to-do-the-math-2011-05-24) and the year-over-year growth necessary to justify the current price point will be hard to match.
I see some seemingly outrageous valuations north of $50 million pre-money for companies that don’t have revenues, customers, or a stable product. Some of them are obviously bogus. Some of them get funding and I am asking myself what I could have missed during the due diligence that others saw. I guess I will find out in a few years.
And then there are the companies with a valuation north of $50 million pre-money that deserve it. The problem is, there are four or five competitors, targeting the same market, with the same story and valuation. Together with accelerated market behavior, lower market entrance barriers, leaner startups, and wider reach than ever, the Discounted Cash Flow (DCF) analysis or Internal Return Rate (IRR) calculation leads easily to a $50 million valuation. On top of that, DCF and IRR calculations of early stage companies are crystal balling anyways for anything beyond 9 months. So I’ve recently seen two of these – let’s call them Startup A and Startup B – and the discussions went like this:
We are the super-duper VC X from Sand Hill Road with the best inroads into telecom carrier vendors such as Cisco, Juniper, or Oracle. From our past experience, the only viable way to address the problem P is to have a strong carrier vendor play, and our previous exit are the proof. And because we are the only one that can really help here, we will have a $10 billion exit with Startup A.
The next VC said about Startup B:
But we are the super-duper VC Y from Page Mill Road with the best inroads into Google and Facebook. From our past experience, the only viable way to address the problem P is to have a strong play with over-the-top Internet giants, and our previous exits are the proof. And because we are the only one that can really help here, we will have a $10 billion exit with Startup B.
As you can see, both VCs X and Y have quite plausible explanations for that kind of valuation and approach. If the companies are truly competitive, may be the market is large enough for both of them. And maybe the upside is large enough for both of them to make a $50 million valuation realistic as well as attractive for VCs. I think, though, that more and more startups take higher risks in terms of go-to-market strategy, resource planning, and technology expectations. The thinking is, I guess, that higher risks bring higher upside and justify bolder valuations.
Moreover, the market of venture capital seems to demand these risks, as I see VCs as the demand side – not the supply side! – of valuations and investment proposals. There are countless cases where I hear startups talking about how in one year the VCs said “what, you only need $1 million? What could you do with $5 million?” and then in another year they answer “Why $10 million? Couldn’t you do a round with $2 million?”
After a “wasted” two years during the recession companies lost a lot of value, investment managers were cautious, and good investments hard to come by. I wonder if the risk taking is due to the fact that some funds still need to make their money back to get to black zero, and hence the investment managers are now scrambling to the end game… hence the high risk taking.
However, low risk adversity does not equal brainless spending sprees. And while some markets seem to do exactly that, I am looking forward to the B rounds in a year or two…