Monday, November 17, 2014

When Numbers Get Serious

As the Paul Simon song goes “… when times are mysterious serious numbers will always be heard…after all is said and done… two becomes one.” This may explain what is happening in the Venture Capital driven tech world with its current nose bleed valuations/pricing. Venture Capital, like its related deal market cousins-Real Estate and Private Equity, is cyclical. Venture Investing is based on funding capacity not fundamentals as investors, especially limited partners, chase past yields.

The cycle runs as follows:

1)     High returns from successful exits triggers more fund raising
2)     Funds scammer to invest raised funds leading to increased deal competition and pricing
3)     Higher pricing producers lower returns and accidents which reduces fund raising
4)     Less funding capacity leads to reduced pricing, better deals and higher returns
5)     Repeat cycle

Funds are unable to resist due the Prisoner's Dilemma problem. We last saw this in the 1990s with the dotcom boom and bust. The bust lasted until 2012 as funds worked thru their problems and investor memories dissipated. In 2013, Venture Capital enjoyed its highest return since 1999 according to Cambridge Assoc due to some highly successful IPOs. Investors rushed in to invest and fund raising exploded. Tech pricings have followed suit.

Venture funds have developed a new approach to invest this embarrassment of riches accelerated funding. It follows from the observation that the highest returns (note-NOT risk adjusted) are from the largest exits. In this winner- take- all environment (first mover advantage?) it pays to identify winners (start-ups on the verge of breaking out) early and bet/invest heavily in them regardless of current prices. This, of course pre-supposes you can identify those winners before anyone else. This seems like a stretch given the hundreds of firms looking for such winners.

Essentially what is happening, in my view, given the lack of a fundamentals based valuation anchor, is the former series A seed capital financing round is morphing into a hybrid series B growth financing round. Series B, however, had required an externally based proof of concept with a viable revenue model. This seems to missing in the application of the accelerated funding model.  The impact of this development is pricing for IPOs and related M&A is skyrocketing as no one wants to avoid missing the next Facebook. This assumes Facebook ‘s success is based on repeatable skill not luck. The result is great for founders, but scary for investors.

Eventually, prices fall and IPOs fail - leading to a quick re pricing when serious numbers return leading to 2 becoming 1. Paul Simon was very perceptive and may offer some cautionary lessons for tech investors. Venture Capitalist must be attentive of cycles and beware extrapolating recent positive trends.

Sorry to rain on the parade.

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