18 11 / 2012
"The hype" - when values getting out of bounce
It was an interesting year 2012 from an investment perspective - record number of deals especially for Germany. Although total investment sum was not on a record high but single deals achieved impressive valuations caused by amounts invested in a particular round.
I also recognized some conversations among founders when the valuation figure was more in the focus rather than amount raised or ranks of investors. Sometimes I had the impression it was a kind of a game who had the highest pre-money instead looking on the strategic fit of a funding round. Maybe it is all about the money - but I have a different view on this. I do respect that founders need to focus on valuations because it is the most important thing hence they can not defend their position with their own money later on.
In all the discussions I had over the last months I heard the word “hype” a lot. Also I heard a lot the phrase “we are not in a hype like in dot.com bubble times of 2001”. I agree on the later but I believe the term “hype” needs a better definition because it is too broad and too generic. So when we agree we are not in a ‘Hype’ - how do we call ‘the hype’ we are in at the moment?
From a VC perspective we are looking on multiples and valuations - it is about margin on a deal and multiple to cost. So it is about the the level we are investing in a company, the proposed exit value, the difference of this both figures (capital gain) and the risk this projection will turn into reality and the efforts to be made to make it happen as planned. Sounds simple - but sometimes the simple things are the hardest to achieve. In an early stage deal there is a low valuation but a high capital gain, high risk to reach an exit at all and a lot of work in the beginning but less work towards the end after other investors joined the race. In growth oriented deals e.g. late stage deals the valuation is high, the gain is rather low but the risk is also low hence there is a business in place, a good team and due diligence will bring transparency in the risks. I made this overview graph below to give a rough description about the metrics from a VCs perspective. We can discuss on values in general however the general approach what counts when times move on is broadly accepted in Europe - for the US we could apply a certain factor to multiply the values due to exit market opportunities and available funds.
(click on image to enlarge)
I would see “the hype” if valuation of those deals will step out of bounce this metric model. So the metrics are right if capital gains do match with risks and sizes of investments needed to participate. Investing in a company preparing for an IPO lowers the risk and justifies lower multiple to costs. Also it justifies a high investment sum. Getting out of bounce in in such a deal means some parameters don’t match this paradigms. In an early stage with uncertainty of business model, maturity of a team, missing traction in the market and still high risk that the combination of all will be successful the valuation of that deal should not be stretched over the limits. If those deals are valued too high based on business metrics it is an example of “the hype” from my perspective. This is not what happened in 2001. (I’ve been there in 2001 so I know a bit of this time).
We got the first experiences from the US what happens after this “out-of-bounce-deals” were closed. Usually the next rounds will have only a moderate gain - if at all current investors are willing to invest or new investors are willing to join the boat. From a founders perspective this is fine because at least they had the chance to make their deal - if it doesn’t work for the next round they did not lose their chances already in the earlier round. The discussion is not about hype - it is about sustainability - for founders and investors. Also this discussion is focused on the future not on present time. This is why it is so hard to find a common ground in discussions. Only time will tell who is right and who is wrong in his assumption. It will be a discussion of winners - those who could closed those rounds and those who failed to make it til the finish line. I would like to highlight some events from the recent months to consider when talking about “out-of-bounce-deals” and whether or not there is “the hype”: Microsoft, Amazon, Nokia and others made significant write offs on their acquisitions in the level of multi billions of dollars. The dilution of shares and the lower dividends paid to shareholders increased pressure on CEOs and management. They will be more careful about new deals and pricing in the future if they want to keep their jobs. We remember those rumors about Steve Jobs talking to the founders of Dropbox valuing the company at around $800m not far from the point in time they closed a round of financing at around $3bil. Same is true for Box, Spotify, iSquare and other companies. Maybe companies valued above $1-2 billion will only have the chance to exit via IPO. If this is happening in future financial markets is seen to be possible. Even if those companies will go public, those “out-of-bounce-deals” will face a scary fate at the stock market as recent history told us:
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For those which don’t go public, we will see some interesting deal structures to keep the businesses running and keep investors happy after all. If they can pull an Instagram again - we will see. there are still chances for high valued trade sales for some companies. Acquiring Dropbox could still be a strategy for Microsoft: Not for adding users to their services but to offer a solution to let users migrate their online storage manually from XP / Windows 7 to the new Windows 8 / Skydrive integration. Offering an automatic transfer during upgrade might be not that easy to do based on the current components. This would be similar to the Skype MSN messenger migration announced recently. However this deal and its valuation would not be based on business metrics but on the leak of solutions.
Investors today are not gambling on numbers but on their estimation of teams, markets and products. They will limit their risks across various asset classes meaning various phases and markets. Don’t bet that “out-of-bound-deals” will stay forever. Next year we will see some of those failing in terms of sustainability which will have an impact for the next rounds of financing. Even today some investors see the winter coming and stay away from those deals. Getting deals in those times will be key for entrepreneurs in the future.
Times will change as well as the challenges to overcome. Founders who adapt to those changes in time will be true entrepreneurs.
UPDATE: Thanks to those, sharing this view as well this week - welcome on board.
The BUBBLE is Over: http://www.businessinsider.com/e-commerce-startup-valuations-implode-2012-11 by Business Insider & Bloomberg
The lessons from facebook and Zynga IPOs: http://pandodaily.com/2012/11/19/mercenaries-in-the-midst-the-lesson-from-facebook-and-zyngas-ipos/ by Sarah Lacy