Bubbles And Falling Off The Valuation Mountain

March 26, 2014

A popular question these days is whether we are in a bubble similar to “The Internet Bubble” (circa 1998 -2001).  As someone who lived through that craziness as an entrepreneur and both a private and public company CEO, my answer is an emphatic “NO!”

Are valuations notably higher now than a couple of years ago?  Sure.  Are there drivers for this increase?  Absolutely.  Quantitative Easing (are we currently on QE26 or QE27? I lose track.) has inflated monetary instruments, including stocks.  Coming out of a deep recession and a generally improving positive economic outlook (not that it’s devoid of any number of worrisome issues) means analysts’ forecasts are rosier, and, therefore, stock prices are higher in anticipation of stronger revenue and earnings gains.  And of course, with interest rates arguably at zero or even negative, and the S&P 500’s return over the last several years in low single digits, many investors are chasing anything that even sniffs of opportunities for increased alpha.

But better valuations don’t necessarily equal a bubble.  Look at the following data compiled from Bloomberg:

 

Bubble

Now

Avg. Age of Co.

4 Years

12 Years

Avg. Revenue

$17M

$109M

Avg. Rev Multiple

30.0x

5.2x

                                           Source: Bloomberg

Companies completing their initial public offerings today are far more mature, have far higher revenues, and are pricing at far lower revenue multiples than in the late 1990’s.  The revenues for most companies going public today are also far more predictable thanks to newer business models like SaaS, as well as better controls (SOX, etc.), and simply more maturity.  Sure, there are some frothy outliers (Workday?), but generally speaking, public companies are currently priced far more rationally than during the Internet Bubble.

A closely related question that frequently comes up is whether there is a bubble for private company valuations, which are somewhat correlated to public valuations, particularly for later stage revenue companies.  My view is that there isn’t a wide-spread bubble ala 1998-2001, especially in early stage companies, but a) later stage valuations are certainly getting pretty rich and assume a stock market that remains strong or perhaps gets even a bit stronger, b) there are some huge binary bets being placed on consumer web companies (based on far too few public comparables and a handful of extremely pricey acquisitions driven entirely by an acquirer’s strategic reasons, not necessarily the acquired company’s metrics), and c) there have been a series of focused early-stage mini-bubbles in specific sectors for finite periods of time. 

There was a time, for example, when no-SQL database companies received some very bubbly valuations that would require the companies to pretty much become the next Oracle to generate a venture return (you might note that there aren’t many Oracles floating around).  There is a good chance that when the music stops, there won’t be a chair for many of these.  What was most interesting about that mini-bubble and others like it was that those valuations were in play for a just a few months.  Similar companies in the space seeking financing just a few months later couldn’t come anywhere near those valuations, or couldn’t raise money at all. 

The same holds true for the eye-popping acquisition valuations.  All too often, there is only one buyer willing and able to pay those prices, leaving the other players in the market with an impossible “comparable” to match.  To wit, there were a dozen or more Instagram-like offerings, but only one big outcome.  Its musical chairs with only one or two chairs and lots of players – a binary high-stakes gamble for investors and entrepreneurs.

Therein lies one of the real problems in valuing venture companies, especially early stage.  I’ve sat on both sides of this challenge as an entrepreneur and as a professional investor, and it’s a more complicated question than simply a number, or getting a higher valuation than the other guy in the space.  Often, the media doesn’t help to paint an accurate picture of a company’s true “value.” Industry rags report on an inflated valuation (usually minus some very important context and facts) and people start thinking that this recent valuation is now the market.   Entrepreneurs who read the articles (and often their board and advisors) don’t specifically account for differences in the quality of the team, the maturity of the product, the fact that a lighthouse customer or three might already be in the bag, etc.   

Unfortunately, the ecosystem rarely  touts the “retraction” – i.e.: when a too high-valued company fails to meet some key milestones, comes up short on cash, and has to take down a bridge or inside financing round that turns a previously impressive $30M Series A pre-money valuation into an $8M valuation.  I have seen that scenario play out at least a dozen times in the last 18 months in the venture world, and there are many more of which I’m not aware or privy to the specific information.

The point of all this is that with higher valuations come higher expectations and a raised bar. If a company misses on expectations, whether revenue, growth, human capital, etc.-related (realistic or not), anti-dilution ratchets will go into full swing, as do the down-round prices.  Often, the  dilution is greater in these scenarios than if a lower valuation round with attendant lower expectations, goals, and burn rates had been agreed-upon initially. 

Put another way, when a financing is priced at frothy valuations, it represents a multiple that is well above what is warranted by the current company metrics/results.  The investor’s expectation is that the company will grow into the valuation and beyond, quickly.  If that growth fails to happen, either because it’s simply not possible for that market, or because management failed to execute effectively, there will often be a brutal reckoning.  These are the consequences of taking inflated valuations that many entrepreneurs don’t hear about, and they don’t teach you at your favorite GSB.

So, as you consider a valuation for a financing round, be very mindful of the stated and implied expectations that come with the valuation; the bar it creates for the organization (and you) in terms of the scale (revenue, users, etc.) that you will need to grow into on the new capital; and what kind of valuation you need to command in the subsequent financing round (private or IPO).  The higher the mountain you have to scale, the harder and less likely it will be to accomplish, and the farther the fall if you don’t reach the top.