From: Esfandiar Bandari <e.bandari@gmail.com>
Date: 8 February 2015 at 23:40
Subject: private blog: On valuations, exits and bubble in SV -- some mathematics
To: Esfandiar Bandari <e.bandari@gmail.com>
There has been a lot of articles, including in the WSJ, about a potential bubble in Silicon Valley. Indeed, couple of weeks ago Crunchbase had an interesting survey on the same topic.
This post is to get my thoughts on the topic down and use it to predict where things are heading (and how that would effect Textnomics).
So here are 3 main questions:
1) is there a bubble? -- we'll take a simple outcome based approach to this.2) if so or not so, what is the cause of high valuations?3) what comes next?
Let me give a quick synopsys here: Not all valuations are justified, because some of these companies will neither go through an IPO or an M&A -- specially M&As that will have the huge valuations they have been given.
Government policy, specially taxes on the money parked overseas, can really improve the M&A situation and keep the valuation higher. Most important factor, IMHO, is the stock markets and frequency of IPOs, of course. I will also see some IPOs happening in markets overseas -- London for instance -- where going public is easier.
OK, so Is there a bubble in valuations? Lets define Bubble as unjustified high valuation that will eventually collapse suddenly or deflate over time.
So are the valuations too high? Simply that depends on one factor and one factor only!
Are the companies being funded going to exit with a higher exit value?
A less likely alternative to this is, if these companies give high enough dividends and returns to their investors? There is also one other sane way of analyzing valuations -- NPV (net present value). It is perhaps one of the better incomplete measures, and very frequently used in valuations for public companies. But NPV does not tell you about the market trend, but rather individual companies.
Going back to exits as the main determining variable in valuations, there two: M&A and IPO.
Lets take M&A's first. Many large companies, Apple, Google, Facebook, etc. are sitting on large piles of cash. Some are also in a frenzy to buy start ups, that goes beyond the usual evaluations of Risk, Return and Strategic Intent. Three reasons that I like are:
1. they see strategic value and monetization in their purchase -- eg. Facebook paying $16B for WhatsApp which will have a $1B a year return by next year, give FB a 6.25% return on its investment. This is on top of the large purchase tax write off.
2. They do not want their competitors to buy the company. You can chalk this up under Risk or Strategic Intent; example, what Google should have done with PowerSet but failed to do so, and it went to Microsoft for a $100Mil (perhpas a fraction of Google's daily revenue at the time).3. and finally, perhaps most importantly, how well the VCs can arm twist larger companies to buy their portfolio company. Examples? Facebook paying $1B for Oculus (thanks to A&H), Google paying $1.77 for Youtube (still one of the worst buy outs, in my mind), and Cisco paying nearly $600M in 2007 for Pure Digital Technologies, the company making the Flip camera (thanks to Mike Moritz of Seqouia).
Personally, I think number 3 is a huge factor and often overlooked.
A bigger determinant than M&A valuations, is the IPO market. Will there be more IPOs and will there be high valuations? Yes, and Yes. The curse of SOX is mostly removed, and the VCs have learned to live with it. This was a huge cold blanket on exits. Public markets pull M&A's up, They are also a fairly balanced comparable.
They are a strong and true alternatives setting high valuations on potential future competitors. The question is will the public be willing to pay such high values for tech companies, as it did for Facebook? Well for one thing, "the Public" now a days are mostly institutional investors, and they are keen. In fact, now (i.e., at the time of publishing this blog on blogger) the hedge funds are getting into the start up investment market. This goes beyond the greater fools theory, and in fact, it makes an often less considered factor more important; the macro economics effect. Something nobody talks about, but which definitely effect the companies doing Acquisitions (with a capital A).
They are a strong and true alternatives setting high valuations on potential future competitors. The question is will the public be willing to pay such high values for tech companies, as it did for Facebook? Well for one thing, "the Public" now a days are mostly institutional investors, and they are keen. In fact, now (i.e., at the time of publishing this blog on blogger) the hedge funds are getting into the start up investment market. This goes beyond the greater fools theory, and in fact, it makes an often less considered factor more important; the macro economics effect. Something nobody talks about, but which definitely effect the companies doing Acquisitions (with a capital A).
Look at the last bubble, right after Dick 'n Bush came to office, we had a burst of the internet bubble. People said the economy collapsed because there was an internet bubble. On the other hand, some can as easily argue that valuations collapsed due to huge tax breaks to oil companies, followed later by 9/11 and rise in gas prices, thus evaporating the Clinton Era Budget Surplus and turning it into $6T deficit.
Currently, the US economy is doing well. Future US policies, particularly the election, can have a huge effect on providing incentives for M&A -- one way is to make the cost of parking corporate money overseas more expensive.
Other major macro economics effects are -- rise of the crowd funding, deflation of start up costs, creation of new markets such as the App Market and the Sharing Economy, and globalization of these markets, something that was not there in the 2000.
2) What caused these valuations? I would say there are at least 3 factors.
One of the most important ones often overlooked was that VCs were sitting on billions of dollars for 3 or 4 years and not investing right after the banking collapse. So this money was bound to get invested.
Second factor, IMHO, is a psychological one and was the $100B valuation of Facebook during its IPO. We saw the same rise in funding after Google went public. Every investor wants to be on that bus. Call it greed or priming the pump, but it works. Look at AliBaba's valuation. But lets face it if Facebook is worth $100B on its IPO, then so should be Uber, and AirBnB, easily. A balanced view will also point to the valuation of WebVan and Pets.com. Those are very valid warning signs that can point to local bubbles in certain sectors (personally I do not get the food delivery businesses! But then again, I have not studied them).
Third and finally the most important factor strategically, is that pushing a higher valuation on companies, then justifies huge exit valuations. That is why WhatsApp took more money from Sequioa, even when they did not need it. I doubt that Uber needs all that money they are raising either; they want the higher valuation before they go public.
This assumes two things: 1) there will be a high exit, either M&A or IPO. 2) if it is an IPO, "the public" will pay, be it as shrewd investment or greedy people holding the bag. In the case of Facebook many people were not sure right after the IPO. In the case of M&A, then some other Cisco that will pay a bundle for something, hoping they can monetize it, or stop somebody else from buying the company.
3) Finally, what comes next? This is the hardest part. I think things will get better in the short run. AirBnB and Uber will go public. The issues around SOX have been resolved already but will be non-issues even further. This means, more investors will want to be on those band wagons. And hopefully, SEC will get off its horse on crowd funding.
There will also be massive M&A exits, but I think it will be by top tier VCs. But the key factor will still be The Performance of The Public Market and IPO Valuations. If you are investing in a company that will not match its valuation during IPO, specially given that you will not have a liquidation preferences, you are highly likely to Lose Big Time. Facebook is not a good measure for the future. FB was not a good measure when it had a 15B valuation and no revenue. But FB had a story, as did Google. FB advertisers are still new and more than likely are not getting real value in given their profit margins (eg Zynga). But much like in the case of Google's early day revenue, these advertisers feel that they need to have a presence. You can wrap it up in nice phrasing as in social validation even without intent. Regardless, the FB analogy, is a false one.
Therefore, I do think there will also be major failures. I think these will be later stage companies that are raising 100M in Series H and they need the money to keep up with their expenses rather than investments or as mezzanine money to go public. As for the earlier stage companies, the series A fund raising will still be an unfortunate barrier -- in a micro economics sense of it.
I know I have been harping on this, but another factor is the overall macro economic effects. Just like SOX put a damper on IPOs, the government particularly the Presidential election can play a huge role. Most investors want to ignore this, but if there is one reason to look at the last bubble, this would be it. Silicon Valley is a smart, highly educated, and liberal place. Perhaps not in the short run, and not in a massive way, but who gets elected President can have a slight boost or decrease in the valuations, the investments, and their success and failure.
Just as important, if not more important is China, oil prices and Europe. Deflation in Europe is a major threat. But deflation around technology has been in there for a long time. It is the slowing of the economies that may have an effect on how much big acquiring companies are willing to pay. These companies will also look overseas for M&As. Ironically, one thing that can help the MA& economy is the shyness of government to do something about the large company profits, parked overseas. Another boost will be for some of the US companies looking for exit, to go public overseas; specially LSE. The US VCs may not be that familiar with it, but when there is a will...
In summary, I expect the valuations keep going up for a while, at least till late 2015 early 2016, and depending on the election results. This will be intermittent, hopefully, with some minor local bubble bursts or deflations in sectors or companies that simply do not make sense. I also think after the first few major and well known IPOs we see a flattening out. I expect those would happen by winter of 2015. Till then hopefully there will be other promising companies coming into focus, the government will get its act together with regards to taxing profits overseas (incentivisng M&As) and crowd funding. Global economy, particularly China and cost of fuel and spending will play a role. But IMHO the main factor will be the public markets, specially NASDAQ, in the US and to a lesser extent overseas (eg LSE).
