This article, which previously ran in affiliate publication Venture Capital Journal, was written by Ken Elefant, a managing director at Intel Capital who focuses on security. He can be reached at email@example.com.
The private equity markets are in the thrall of what mental health professionals call normalcy bias: A kind of denial that lets people underestimate the possibility of disaster and read warning signs in the best possible light.
Make no mistake: there is serious danger ahead. In the name of unicorn chasing, investors have gone from valuing companies based on fundamentals to valuing them based on near-term future revenue growth, and then blowing past that measurement to where valuations now are being based on several years of projected revenue growth.
This is no way to run a business, let alone a financial market. Yet many investors remain blind to the idea that current valuations can’t be sustained, even as public markets are starting to come to that very conclusion.
As an investor with 16 years of experience and the survivor of two downturns, I’m convinced the market is going to return to valuing companies on their fundamentals. This means on actual sales and robust pipeline due diligence, not on long-term projected bookings…on real, achievable profits, not theoretical ones.
When is this correction going to happen, and what will drive it? Pick your poison. It could be a rise in interest rates. Or a high-flying sector leader restating its numbers. China’s growth rate could slow. Job creation in the U.S. could stagnate.
One way or another, the venture markets are coming back to earth. So my advice–whether you’re a venture firm, an entrepreneur getting started or a portfolio company with a round or two of financing under your belt–is to think for yourself. Do what you think is the right to build a long-term sustainable company, and look at the metrics of your day-to-day operations.
If you conclude that the valuation bubble is going to burst, you would be wise to take a few key steps to minimize the impact of the eventual economic fallout I’m convinced is coming.
Because when a unicorn trips, there’s a good chance it will come up lame.
Our own worst enemy
As always, the venture community is its own worst enemy in this latest run-up on valuations.
We look at the better IPOs to date, and there have been some good ones, and convince ourselves that what we’re chasing is just as good. We plow cash into late-stage investments, thinking that they’ll be the next big thing and generate the next huge exit.
The number that best makes the case comes from a February write up in Dow Jones VentureSource. It reported that the median pre-money valuation for all venture rounds in 2014 was $40 million, up from $20 million in 2013 and exceeding the $25 million median price during the dot-com boom in 2000.
Stop and think. Is the same startup from 2013, with exactly the same fundamentals, really worth double its valuation just one year later? Of course not.
So why is this happening? Gary Solomon at GGV Capital identified four important traits plaguing the venture community in a recent blog post. They include having few good opportunities, a history of overpaying while still getting decent returns, the drive to land the big logo, and a fear of missing out on the next big thing.
These last two traits, chasing logos and the fear of losing out, are lulling some investors into the sense that it will all work out.
The data seem to confirm this sense of denial. Perhaps the most telling are in a report published last fall by SVB Capital, which found that despite all the warning signs, the venture community was evenly split on whether there will be a significant change in valuation in the next 12 months. Even the authors of the report were surprised.
Because history tells a different story.
Remember when Groupon burst onto the scene? Suddenly, more than 300 companies were doing the same thing. Same with Zynga. Or cleantech. Want something more current? Take the Internet of Things. How many more companies, really, can expect to be the next Nest or Dropcam? Certainly my Intel Capital colleagues who invest in IoT are taking a sober approach to weighing opportunity and risk.
So is anybody else paying attention to today’s overvaluations? Interestingly, the public market is figuring out what the private one can’t yet admit.
A recent article in the Wall Street Journal cited a study by Barclays of eight high-growth public companies whose multiples dropped an average of 6.6 times spanning 12 months from the first week of March of 2014. Yet private valuations are still through the roof.
I’m surprised we haven’t had a correction yet. But there’s no time like the present to prepare for one.
Four things you can do right now
If you’re an entrepreneur with a great idea, or a venture firm wanting to fund one, what can you do in an overvalued market? There are four basic things.
- First, keep an eye on the Federal Reserve. When interest rates finally rise unexpectedly, the stock market will correct itself downward. Deep-pocketed investors, who until now have had little choice but public and private equities to get a decent return, will then spread their risk across bonds and other fixed-rate investments. The result? There just won’t be as much money to go around.
- Second, stay focused on solving real problems for enterprises and consumers. Consider our former portfolio company Prolexic. While its Hollywood, Fla., location is a bit off the beaten path, the company’s focus is a mainstream enterprise problem: denial of service attacks. It’s had real success, made real money, and the high-quality management team sold it for $415 million last year and made a solid return.
- Third, make sure your burn rates are sustainable in good times and bad. Because when the fallout hits, it will be years before today’s limited partners feel comfortable enough to wade into the venture equity pool. Make sure your burn rate is also appropriate for your growth. But also make sure you have a contingency plan. Not enough companies have one in place.
- Lastly, if you’re an entrepreneur looking for initial funding, pick a firm that invests through good times and bad. You’re in it for the long haul; they should be, too. If you already have one or two rounds under your belt, don’t be afraid to have a frank conversation with your investors about the state of their portfolios. If the firm backing you is overextended, or if you’re working with a junior partner at the mercy of senior leaders wanting to protect their own investments, you could end up starved for cash and sold at fire-sale prices.
When, not if
The bottom line remains the bottom line: investors are looking for returns and are looking to us to deliver them.
On our worst days we ignore the numbers, try to redefine standard terms such as multiple, or proclaim that this sector, this time, is different from the last. We tell ourselves a story that just isn’t true.
But on our best days we look at the fundamentals, are honest with ourselves and candid with our investors. What I tell my portfolio companies is that the return to fundamentals is a matter of when, not if. I tell them there’s a game of musical chairs afoot, and someone is going to be left out. I tell them I’ve already grabbed my seat.
Make sure you do the same.
This guest column first appeared in affiliate magazine Venture Capital Journal, which is published by Buyouts Insider. Subscribers can read the full column and other exclusive content by clicking here. To subscribe to VCJ, click here for the Marketplace.
Photo illustration courtesy of Shutterstock.
Photo of Ken Elefant courtesy of Intel Capital.