GETTING UP ON THE DOWNROUNDS

In the 1st quarter of 2015, we saw how different P/E levels were of top 5 NASDAQ companies by market capitalization now (average of ~21x) versus in 2000 (average of ~85x), the profitability and mean age of companies at conversion to public markets and felt pretty good about the scene. VC dollars have continued to pour in since then and as of today we have 144 total unicorns (46 created in Q2 & Q3 2015) in the world. The continuous influx of capital from a myriad of sources into the private markets have resulted in ludicrous valuations in the startup ecosphere. Investment dollars in the first three quarters in 2015 ($57.9B) already surpassed that of 2014 ($56.5B) in the US and the decreasing number of deals (1035 in Q3 15 vs. 1184 in Q2 15) signified the increasing average deal size in the market; the average Series A and Series B investment size are at $10M and $20M, respectively, the largest it has ever been. The private markets have failed to convert these valuations onto actual dollars via the public markets or an M&A exit, however. In the first three quarters in 2015, the total exit valuation of US VC backed tech companies surmounted to $26.3B only, in comparison to $76.3B in 2014. Recode says technology IPOs on US exchanges were 47% lower in 2015 by deal number and 27% lower by proceeds – and boom goes everyone talking about those valuation down rounds.

Might be a cliché at this point, but let’s bring back Square (company with the poor luck of being used as the archetypical example of why we are at this inflection point due to its recent down round IPO) into the discussion. Privately valued at $6B in its Series E round, Square, the digital payments company, went public on November 18, at an initial market capitalization of $2.9B, pricing 27 million shares at $9 each (and below the proposed $11-$13 offering range). While the stock jumped 45% on Day 1, it has been unable to maintain that upward swing. And not just Square – there are plenty of other companies that were initiated into the public markets at or below their pre-ipo valuation in 2014 and 2015 including Etsy (1x), Pure Storage (0.8x), Hortonworks (0.7x), OnDeck Capital (0.6x), Box (0.6x), Coupons.com (0.6x), Care.com (0.5x), etc. This happened because the public markets are much more frugal when it comes to evaluating the core business fundamentals of a company. But the private markets are catching up: Foursquare reported a new fundraising round that will be a down round and Gilt.com is in conversations with Saks about a proposed sale at a price quarter that of their reported $1.1B private valuation.

The recent disappointing IPOs will discourage other “unicorns” to file their S-1 docs and it will discourage late stage VCs to easily write up valuations (with or without ratchets). For some, like Fidelity, it will encourage the write down of certain investments. And it will encourage the creation and evolution of businesses that focus not only on the quantity of growth but also on the quality of growth via recurring revenue and fixed cost leverage. Ultimately, every startup will be evaluated by Warren Buffet’s simple valuation tool – on the company’s intrinsic value to produce cash in the long term.

While there is no doubt we will see the valuation pendulum swing backwards in the private markets, it will not be at the expense of submerging innovative products and solutions. Although an unsatisfactory exit, Square did build itself into a public-markets ready company in 6 years, creating a novel product that has impacted millions of businesses to date. Facebook too had a disappointing entry into the public markets but have steadily increased in value (share price of $38 at inception versus $104 today). Amazon too only but just turned profitable for the first time in Q2 2015, having gone public 19 years ago. 2016 will mark the year where we will better understand which unicorns prove to bear the characteristics of a sustainable business. To shovel off the naysayers, companies like Square and Box should be all heads down, striving to focus on their business fundamentals to sustainably grow earnings and to evolve from being “magical” to “realistic”. 

 

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"Price is what you pay. Value is what you get." - Warren Buffett