From time to time entrepreneurs ask us questions, not so much about their own operations, but more about outside forces that are putting pressure on their numbers. Here, I’m keeping it simple by answering the top three questions we get asked most often about the markets these days, explaining how they may have affected your company’s valuation—and what you can do about it.
Q.) “The stock market is down 10%, but VCs say my valuation is down by half! What’s up with that?”
No surprise, the public markets affect the venture capital market. But it doesn’t work the way most people think.
If a VC invests in your company at a valuation of $10 million, your company is not actually worth $10 million. The VC is buying an “out-of-the-money option”. In layman’s terms, she is making a bet that your business will become more valuable over time. The stock market impacts the price of this bet, but so does risk and time-to-exit.
Let’s put some context around this. Consider two companies. Company A is expected to go public this year at a $500 million valuation. Company B has the same potential $500 million outcome; however, it is going to take a few years and they only have enough cash to last 12 months.
One obvious issue is that Company B needs to be funded before they run out of money. Every financing adds risk and dilution (remember when Facebook had a down round?). That is one reason why Company B trades at a discount. But the employee side of the equation is just as important. Start-up employees are not indentured servants, so shareholders should expect a couple percentage points of dilution every year for new option grants. This adds up over time – over a ten year investment we normally see 30-50% dilution just from employee options.
In the past two years a lot of investors thought they bought shares of “Company A” and woke up to the reality that they actually own “Company B”. That is why Fidelity and others have marked down their private portfolios. Meanwhile there have been zero tech IPOs so far in 2016 and M&A in the first quarter was at a multi-year low. When you put all this together, you get a valuation drop well in excess of the day-to-day changes in public multiples.
Q.) “Is this going to change back soon?”
There is a chance that Uber could lift the market if they go public in 2016, just like Facebook did in 2012. Facebook’s momentum helped raise all valuations for a while, although in hindsight it was a temporary fix.
The underlying issue is that the US is “demographically-challenged”. Baby boomers are not only more numerous than any prior generation, but they are also the richest. Nearly half the capital in the US is held by people over age 65. This population is entering retirement and living off savings. They also survived two major recessions in the past 15 years, so they are searching for safe investments. Speculative investments are simply out of favor, and the valuations growth companies get in the public markets aren’t that attractive right now.
The upshot is that foreign investors, particularly from Asia, want access to high-growth US companies to diversify their portfolios. This new capital has the potential to help counteract some of our domestic issues. It is just one more reason why free trade is so important.
Q.) “As an entrepreneur, what can I do about this trend?”
If you raised capital at a very high price – and you know who you are – the best plan is to get profitable with your current cash. That buys as much time as you need to figure it out.
If you are in a situation where conserving cash is impractical, or impossible, have a conversation with your investors about what they expect you to accomplish and how your business will be valued in the future.
A good exercise is to compare how much cash you are spending each month with how much value you are creating. For instance, if your business is valued at a multiple of revenues, focus on the ratio of annual recurring revenue you add for every dollar you burn. Make sure there is enough leeway in this math so that you can raise capital at a reasonable step-up to your last round.
If you are just starting up and haven’t raised money yet, now is a good time to dream big. VC funds still have a lot of capital – if you look at Greycroft, we have raised $800 million since the firm’s inception (across all our funds) and about half that money is still uncalled. I expect the same is true for funds like First Round Capital, Andreesen Horowitz, Spark, Union Square Ventures, First Mark, General Catalyst, etc that all emerged around the same time we did.
By “dream big,” I’m talking about envisioning a company that has large-scale ambitions. Despite the apparent gloom-and-doom scenario painted above, there is always a market for great, visionary businesses. The start-ups we like to invest in have several things in common: Big barriers to entry; a top-notch management team; and a huge potential market. Create these, and you’re on your way to start-up success.
For more details on what we’re investing in now and why, stay tuned for my next post.
Ian is a co-founder and partner at Greycroft Partners in New York City. He has been a venture capitalist since 2001.
AUTHOR Thomas Anderson1
Posted on 12:16 pm April 8, 2016.
Great explanation on valuation as placing an out-of-the-money option on the investment. Smart people can always communicate complex issues simply.