The Sky is Falling
Last night I ran into a new seed investor in San Francisco who I really like. I was asking him how he liked the move into venture and, as you might expect, his response was extremely positive. Beyond the standard awesome things about investing in early stage startups he capped his response with the phrase “and it’s the best possible time to be doing what we’re doing.”…I sort of paused for a minute… my response: “really dude, are you sure? because I’ve been mashing around a macro analysis in my head for the last year and a half, spending significant energy trying to understand the cycle we’re in, and I’m not sure you’re right”…I’ll caveat this analysis with a precursor that what I am about to say should in no way dissuade early stage entrepreneurs from starting companies right now, and in fact should not dissuade smart investors from deploying capital right now…but it may well change the profile and complexion of investments I make over the next 12 months…how…I am not 100% certain of, but I’ve got some ideas…anyway below is what I think is going to happen in our market on the next 12 months:
1) I used to think that that the public tech/ipo market would correct before the private tech market…I now think that is wrong
2) As I articulated in my 2012 predictions, I believe Facebooks IPO will be the top tick of the tech cycle, but here’s why:
- Facebook will crush their IPO, but it really doesn’t matter at what price
- A sea of scaled venture backed companies will go out in the months before (already happening), during, and after Fbook IPO
- The dumb, retail fueled public market will value this slew of tech IPO’s off of Fbook and Fbook derived multiples without an understanding of “social network A” from “social network B.” Said another way, with no understanding of true market position, actual value, and the difference btwn disruptive and disruptable…the public market will trade Carbonite for example along similar axis to Dropbox… (see Bill Gurley’s awesome post for more on this)
- 3-6 months post the flood of IPOs, the market will rationalize and stratify…smarter and more sophisticated analysis will buoy 15-20% of now public tech companies that deserve the “hot multiples” and the remaining 80% will take a beating and level at “true value”
3) Ok, so that’s the public market…3-6 months, might be 6-9 months (I wish I had seen previous cycles to know better)…but how will that impact venture and early stage venture? This link took me a long time to solidify, and this is still an assumption, but if this piece is true, I think the venture market becomes illiquid in December of this year…
- With a flood of public comps (as we know venture market valuations are largely irrational and often derived from market comp analysis that goes something like “if Instagram is worth $500M then AirBnB is worth $1 billion”)…but I digress…as I was saying…with a flood of public comps now “rationally valued”…the late stage private market will recalibrate…and all of the sudden all of the $300M-$750M fund size venture firms that got greedy buying hot assets at valuations north of $200M (especially writing $20-30M checks into them) will realize that they have a bunch of “underwater assets” on “their books” that will 1) not be able to raise another round of capital at a step up in price and 2) not be able to IPO or sell through M&A at a step up in price
4) Ok, so how does this affect early stage venture market?
- With underwater $20-30M checks on the books, even really good venture firms who traditionally play in early stage Series A type investments will develop a fear that their own fundraising efforts (in a market that is contracting organically anyway), will be harder because they made a bunch of bad bets and their LPs will know it…so when Princeton is deciding which 5 of the their existing 20 venture managers they will continue to support…the ass hole who paid up at $1B valuation for an asset that’s worth $150M is not going to make the cut
- This fear will lead to a massively slowed pace of capital deployment at all stages because the funds will not want to shut doors, rather they will try to “wait it out” or “wait and see” and a large volume of $ will dry up in all stages from Seed-Series D. Even though there will be many funds not really affected by the dynamic I just described, many of the thought leaders that the market looks to and follows will behave this way…and group think will have the “dumb 50% of the market” following the smart guys and slowing down as well…fear sets in…market dries up
5) So what does this mean for entrepreneurs?
- Already, you’ve gotten the advice to capitalize now and prepare for winter…but you’ve been getting this advice from “chicken littles” for a year and a half. Suster called bubble 18 months early, Fred was early…and frankly I may be early too…but if you think I’m right, then obviously you want to raise as larger a round as you can in the next 9 months…understanding that if 5% of the venture market is thinking like me today, and I am right, it will be a gradual shift, where 20% will be thinking like this in 4 months, 50% in 9 months, and then the rest of the ass holes will continue to be in denial until they read the New York Times headline that says “the tech world is melting”
- More practically, perhaps you want to think about building cash flow businesses. This thought makes me sad, because I prefer to think about world changing technology and huge disruption which tends not to generate cash flow in the short term…but sadly the change may support your focusing on “commerce 2.0” and other non-disruptive businesses that actually do make money…
- IF you’re raising money from large venture firms, ask them how they are reserving against your company. You’re gonna need their help to get through the illiquid period and into the next liquidity window
i. But when will the next liquidity window emerge? I don’t know…I think this driven by the amplitude of the correction…which should be less sever than 2000…because our industry is more mature, etc…but I’d say at a minimum 12 months…
I know people say you can’t time markets…Fred wrote a post to this effect that sort of pointed at Andreesen Horowitz…which like it or not, I think has sort of brilliantly timed markets…but what fun is this game if you’re not willing to put your name behind a thesis and make your call? Worst that happens is that you are wrong…so this is my guess as to when the world ends…please improve it or point out flaws in logic…it’s meant more as a catalyst for learning than a decree…
Jordan Cooper's Blog: startups, venture capital, etc... 
If sure does feel this way. My taxi driver index went off six months ago when I saw one wireframing a food delivery site. He was the same guy who bought 3 houses in 2007, and webvan in 2000. What is different this time is that it is only sophisticated investors taking the hit and not retail investors. Thus, absent a big macro event, this still continues to be a thrice in a lifetime activity. Thank goodness for 501(d) or this could have been a much larger bubble. That said, this cycle is a technology secular bull of disruption not withstanding this cyclical pull back.
Richard Weisberger
March 1, 2012
Some great thoughts Jordan. Couple of points:
1) I agree public equity investors are still getting “comfortable” with newly public tech companies, so I agree that in time they’ll discriminate further in terms of multiples. But I’d argue that at the macro level they’re already doing a decent job of this. Just to take your example of Carbonite… it currently has a $239M mkt cap, has $60M in trailing 12mo revenue, and something like $80M in annualized bookings (based on Q3 ’11). So it trades at 4x revenue and only 3x bookings (more common metric for SaaS businesses), which is a fraction of the 10x+ multiple Dropbox garnered. So I think a number of weaker companies will continue to see multiple compression in their valuations, but less clear to me it’s going to be a drop off a precipice.
2) There will undoubtedly be a contraction of VC funding as you point out. In 2011 depending who’s estimates you look at, something like $25-30B of capital was deployed by the industry and something like $15-18B was raised. Forget whether firms have late-stage investments that are underwater… the basic inflow/outflow of capital is obviously unsustainable.
The question is not what Princeton (as a proxy for “elite” LPs) will do however, because these groups have been selectively winnowing their fund relationships in recent years. The question is whether other types of institutions will allocate more capital to the VC asset class. I’m actually doubtful that you’ll see a flood of capital from public pension funds like you did in the 90s or sovereign wealth funds in the 00s coming into the VC asset class, but it’s possible there will be some rebound as some LPs perceive VC as attractive again because of the wave of high profile tech IPOs.
3) Usually when people say “it’s different this time” it’s simply a justification for a unsustainable bubble. There is one objective difference in this cycle though, which is that the capital needs for starting a company (at least a software-based one) have come down dramatically with all the attendant changes in the funding landscape. There are clearly a lot more companies being started and getting funding at least at small scale (e.g. $100B was raised annually in the ’99-00 cycle) or that it’ll be bad for the overall ecosystem (obviously it’s hard on startups and VCs that are unsuccessful).
So bottom l line agree with your broad thinking that a contraction is coming. I think it’s possible whatever contraction occurs will be perceived as very significant (see #3). But in reality I also think it might be a bit less severe than you’ve portrayed. We can settle up in 12-18mo and see who’s right 🙂
Lee Hower (@leehower)
March 2, 2012
Hm so you know I agree with part of this .. but or the sake of discussion/improvement/etc./etc., a few thoughts:
– Agree that the Fbook IPO will be huge and should be huge. I think the company’s just getting started.
– I’m not as convinced as you that public-market analysts don’t understand the internet and will have trouble differentiating between social network A and social network B. Part of it is that they’re (broadly generalizing) allegedly-smart people who are paid to spend their lives learning and thinking about this stuff .. and part of it’s that even if you think one site has weak network effects, it still takes time for those to decay, you’re going to see it in revenue numbers (or lacktherof) before you get Myspace. Analysts will pay attention to those.
– Put differently, by example: I’ve been pretty impressed by analyst reports about Zynga. Maybe it’s a case of low expectations trumping all, bu they haven’t been totally off base.
– I think the underwater assets –> poor fund returns –> fundraising difficulty cycle takes closer to a decade than a year to play out. Even if you think that it’ll happen (more on this below), it’ll not be a 2012/2013 thing.
– Venture market stratification means that maybe it’ll not matter that some big funds have a bunch of later-stage checks underwater because those funds also wrote big checks into the top 10-15% of companies, and those winners will carry the day (and the fund.) The firms that don’t have winners — well, they’d be out anyway (asset class is contracting, etc., etc.), and now they’re out a little faster than they would have been. Ah well.
– You seem to think asset managers at the big endowments are able to make autonomous (or semi-autonomous) decisions based on data .. which, although it sounding reasonable, is actually rather difficult from what I’ve heard.
– Even if those top-tier American asset managers make fully-rationale decisions, maybe it doesn’t matter: There’s a lot of global money looking to get into early- and middle-stage tech, and the new stuff — most of the global money — doesn’t have the relationships to get into the top x% of funds. They’ll move down a bit, at a lower return, to get into the asset class.
What am I missing?
christina cacioppo (@christinacaci)
March 2, 2012
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