Valuation Crush

Ian Hathaway isn’t an investor.  He blogs about startup stuff and is an economist.  He looks at data.  That can be insightful.  It shows the paper trail of where we have been and if you have good data, along with good projection skills you might be able to look into a crystal ball and discern the future.

Of course, we all make mistakes which is why macroeconomists are rarely right on their ten year predications and entrepreneurs are rarely right when they show you a five year top line revenue growth projection.

Ian’s blog the other day is packed with information about startup funding and valuations.

It’s well worth a read if you are into this stuff.

If you are younger, you might not realize that short term interest rates can go above 0%.  When I was in high school back in the dark ages before they invented calculators, short term rates spiked to 21%.  Neither was normal or even close to normal.

I think we will see a normal discount rate within the next couple of years.  3-4%.

To give you some context.  My first home loan was at 12.5%.  My seat loan was at a point over prime at 9.5%.   For the seat, I put 50% down and had five years to pay off the rest.  That was a little high relative to the traditional cost of capital but even today, the cost of capital is a pittance to what it will be.

That’s going to affect startup valuations big time.

Why?  Because there are risk/reward preferences among the investor class and pools of capital that put money into funds that play in the startup land.  They will shift money from chasing return in risky assets like startups and PE, to more certain returns in interest rates and corporate bonds.

Ian writes,

Here are the key takeaways of the analysis I’m about to present:

1. There are fewer deals at the early stages, especially at the Angel/Seed stage but also at Series A. The number of financings at Series B and C are about flat, and for Series D and later, the volume of deals has also come down.
2. Deals may be down, but the amount of capital deployed is going up as companies that do get funded are taking on much larger amounts of capital—this is true across each individual stage (round sizes) and cumulatively over the lifecycle (total equity invested). This trend has been most pronounced at Angel/Seed and Series A.
3. With more capital being raised, valuations have unsurprisingly been increasing too—with the most growth at Series A and from Series C onward. The least amount of growth in valuations has been at the Angel/Seed stage and at Series B.
4. However, these figures have not expanded equally—capital raised has grown more rapidly than have valuations. This means that the equity stake taken by investors is going up while valuation multiples (a rough proxy for investment return) are coming down. In other words, every dollar that investors put into a startup today nets them a bigger slice of the pie than it did a few years ago. Similarly, for a given valuation threshold, companies have to raise more money—and give up more ownership—than they did in the past.
5. These trends in valuation multiples and ownership stakes are not occurring across all rounds—in fact, they are occurring only slightly for Series B and C and not at all from Series D+. However, at the early-stage—especially at the Angel/Seed stage—these trends are dramatic. I would describe valuation multiples at Angel/Seed as in an outright collapse since 2015, and down meaningfully for Series A.

I think that the collapse of crypto prices and the fervor around crypto ICOs has cooled as well. That will be a tailwind in the drop in early stage valuation.

For our part, we have remained very disciplined around valuation.  We know the math, and we know the risk/reward.  We haven’t outright passed on a company because of valuation, but it does weigh in to the calculus of what to invest in.  Given that in an entire seed portfolio we don’t know which company will be the big blow out and which won’t, being disciplined around valuation gives us better risk/reward metrics to base decisions off of.  To be clear, we wouldn’t write a check if we didn’t think it could be a blow out firm.

I might also suggest that acquihire valuations might go down.  The cost/opportunity cost of operating the firm just changed.

The above is good news for MicroVC which in some cases has had trouble driving returns.  Some of that is because of their strategy.  Some because of higher valuations.  Lower valuations mean you can put more capital to work and get more equity in firms at seed.  If they become blowout firms, you have more equity to work with as future rounds dilute your initial investment.