Pricing to Perfection is So 2015

Jan05, 2016

There is no shortage of stories about rising tech valuations or recent cracks in unicorn valuations. Dan Primack has called the top – or at least peak unicorn – so we’re probably there!

A grizzled VC veteran I know likes using the term “priced to perfection”. I like using it too but think we’ll be using it less in 2016. Good riddance. If you dig into the data and how venture works, rising valuations haven’t done entrepreneurs or VCs any favors.  For context, below are US median valuations over the last four years. They go up a lot. (Note: part of our thesis as Midwest investors is that our region has avoided most of this run-up. Midwest Series A prices are up only 31% from 2012 to 2015 versus 91% for all US per Pitchbook.) On the surface, the growth in US Venture valuations looks great for founders and early-stage VCs. What could be bad about selling something for a higher price?

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Source: Pitchbook

Of course the answer is about “sustainability” and the potential for pain if prices correct. Looking at a growth index of these valuations below (wow!), it is even clearer that a 1.75 to 2.5x increase in median valuations over three years is not sustainable.

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Source: Pitchbook

Yes, you know this already. But why will valuations correct now?

To answer this we need to understand the connection between early and late stage valuations, or what investors “have to believe” to provide higher and higher prices. As founders and early stage VCs aggressively pushed for higher follow-on valuations – and later VCs tripped over themselves to pay up – later VCs compensated by “putting more money to work” to maintain their ownership percent. Below are median ownership purchases by series for each of the last four years. As valuations have gone up 1.75x to 2.5x, so have round sizes, keeping ownership percentages roughly constant. Exceptions are the small decline in Series C and large increase in Series Seed ownership stakes (more on that later).

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Source: Pitchbook

VCs assumed larger round sizes led to a commensurate increase in exit potential

There is an implicit investor assumption here. If you believe that putting more money into a company leads to a commensurate increase in exit size, then higher valuations with more money to work (holding ownership constant) keeps returns stable for both entrepreneurs and investors over time. That sounds great, but can a company that raises $20M on a $100M valuation double its exit potential by instead raising $40M on $200M at the same stage, milestones, etc? In most cases this is not true. In some cases, exit size may in fact be mostly independent of money raised: marginal dollars are hard to spend efficiently, competitors are raising more too and fighting for the same customers, etc… The assumption fueling the valuation trend is faulty.

Unicorn corrections undermine startup prices because they disprove the assumption that exit size scales with money raised.

In the extreme case of exit size being independent of money raised, it’s pretty clear why investors are unhappy. If a VC’s ownership is the same, but the VC spends more to get it, his/her returns are lower. Entrepreneurs should be fine though if their ownership remains the same, right? Nope. Welcome to the world of liquidation preferences. Single liquidation preferences hurt founders and employees badly in down valuation exits, and multiple liquidation preferences (as some late stage rounds are) can hurt even in up scenarios. While trend data don’t yet point to a “correction”, unicorn write-downs foretell a change to come in 2016 because they disprove the assumption that exit sizes scale with money raised. The unicorn valuations that seemed to justify higher earlier stage valuations (and larger rounds) are cracking.

Why now? Thank the flat S&P

The growth in valuations and numbers of unicorns from 20 in 2012 to 144 in 2015 has been correlated with an astounding bull market in public equities… UNTIL public equities closed flat and volatile in 2015. Late stage unicorns are funded and valued by public equity investors dabbling in “private IPOs”. They have short timelines, and unlike in the friction-full illiquid VC market, public investors correct and mark-to-market quickly. In a flat and volatile public market this leads to unicorn markdowns. This in turn drives down early-stage VC expectations of exit potential. If VCs want to keep returns up given these new lower exit expectations, entry prices have to go down. In the end, public and private markets are correlated, and unicorns may be our unlucky link.

So for 2016, expect lower valuations and smaller rounds. Be efficient, do more with less, and stay out from under a big liquidation stack! That goes for all of us – founders and investors.

Bonus on seed rounds: What about the growth in seed round ownership stake we noticed earlier? Unlike in other series, Seed valuation growth has not kept up with Seed round size growth. The 2012 median $600K Seed round on a 4.25M valuation (for a 12% ownership stake) became a median $1.5M round on a $6.14M valuation (a 20% ownership stake) in 2015. Wow! Three times the round size and only a 50% increase in price. I’ve been struggling to figure out why this is – after all, doesn’t everyone claim that startups are cheaper to start than ever? The only good explanation I can think of is that versus a few years ago, it’s now very hard to get good talent to work for an unfunded startup at low pay. The job market is far better, and financings are (were?) sexy. Another prediction for 2016: bootstrapping will be cool again. That’s good because so much dilution early on is tough.

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