Counsel To Founders In This Time Of Uncertainty

The past several weeks have seen incredible turmoil in both domestic and international public markets, and many entrepreneurs and tech workers rightly wonder what impact this will have on them. This is something we’ve discussed at length within the firm — both our impression of what is happening, as well as our counsel to the entrepreneurs with whom we partner.

This crisis is emanating from China, which makes it different in its long-term implications from previous pull-backs. At the same time, the last ten years have drawn our economies closer together; China’s influence over the global economic and capital markets has increased, and shocks in their market are certainly felt in ours. China is becoming an important player in industries well beyond manufacturing: Chinese companies are a major customer and investor for our technology companies, and a tremendous source of both talent and innovation.

But the real effect of this pull-back is the light it is shining on a deeply fundamental problem, one that has been growing steadily since 2011. That problem is the gap between private and public market valuations for technology companies.

The valuation gap is massive, with both consumer and B2B technology companies trading at far lower revenue multiples than their last private rounds suggested. Those public tech companies that remain well on the aspirational side of profitability suffer the worst as public markets looks skeptically on growth, even as late-stage venture and private equity firms appear enthusiastic. Events in China have led to a decline in domestic public market valuations across the board, widening the gap even further — don’t doubt for a single moment that it will have to close, one way or another.

So why are valuations so mismatched? Typically we would say “go look at interest rates.” They’ve been at historic lows, both domestically and internationally, for years now, leaving a lot of cash hunting for yield. If it can’t make a return on treasuries it is going to move into higher-risk asset classes, which will drive prices up, compounding the problem. (For a more detailed explanation of how our economic machine works and the role of interest rates see this explanation from Ray Dalio, one of the most successful “global macro” investors in our time.)

At the end of the day, economic pricing is a question of expectations. Entrepreneurs and investors, trained by what they’ve seen over the past 4 years, expect prices to keep going up. So the net of it is that if this market turmoil changes expectations, then prices will come down.

We have begun to see early signs that this shift in expectations is taking place. The first place to look is at the traditionally public market investors who moved down market into private tech companies, driving prices up over the past several years.

Fewer than a dozen venture-backed tech companies have gone public in 2015, down from 115 last year. If the IPO climate remains chilly then the opportunity for a positive outcome on late-stage private investments is diminished, and those investors will become more selective. Additionally, those public markets investors who hadn’t yet entered the late-stage private froth but were contemplating a push into the sector will back away, seeing greener pastures in a depressed public market.

Finally, large, diversified investors deploy their capital across a variety of asset classes according to sophisticated formulae. With their public market holdings now worth less, they are suddenly over-weighted on private assets. This is unsustainable, and absent a massive rally can be resolved only by reducing private-market exposure.

The second place to look is at the later-stage companies themselves. Many companies raised capital in the past twelve months at high valuations and with high burn rates, confident that follow-on investment would be available when needed, and at an ever higher price.

We are starting to hear about more late-stage, revenue-light companies struggling to raise capital at all, much less at an attractive valuation. Lots of companies go out to raise money immediately after Labor Day, with the goal of locking up funding before the end of the year. Keep your eyes peeled as these stories develop. We’ll know a lot more come Thanksgiving.

At Trinity we debated sending an email to our portfolio CEOs with advice on how to proceed. In the end we decided not to as we analyzed our companies and concluded that most of them were already doing all the right things. We have consistently advised our companies to conduct themselves prudently.

This means one of two things, either (1) manage your burn rate carefully and target rational valuations when fundraising so that you’re not imposing an artificial floor on the next round, or (2) raise way more money than you need for your current operating plan to give you time to “figure things out” or weather a particularly rough storm. Nearly all of our companies are in this position today — we think this is entrepreneurial “best practice” even in good times and have been consistent in our counsel.

As such, we don’t think there is any need for our entrepreneurs to panic. For everyone else we say take stock of your current situation, do what you can to get on the right path, and keep your eyes and ears open. History suggests that turbulent times are the best for entrepreneurial endeavors.