Editor’s Note: Fabrice Grinda is an Internet entrepreneur, angel investor, and co-founder of OLX, one of the largest free classifieds sites in the world. This piece is excerpted from a larger report due to be posted on Grinda’s site, Musings of an Entrepreneur.
As the first quarter of 2015 draws to a close, it’s clear that the venture capital industry is evolving.
Since 2005, thousands of new millionaires have been minted by the IPOs of Alibaba Group, Lending Club, Go Pro, Box, Zendesk, Facebook, Pandora, Zynga, Linkedin, Homeaway, Zipcar and countless others.
Incubators are also proliferating and investing more than ever before: Techstars, 500 Startups and many others have appeared on the scene and Y Combinator classes are bigger than ever. The spring 2015 Y Combinator class has well over 100 startups! Even the emergence of Kickstarter and other crowdfunding startups is tilting the tables in favor of entrepreneurs.
It is surreal to observe investors with no technology experience commit millions in startups after a 2 minute pitch at Y Combinator demo days.
The number of startups and entrepreneurs is also proliferating.The clearest and scariest sign of this bubbliness is seeing investment bankers, management consultants and others, who never normally consider entrepreneurship, join or create startups. This is typically a clear sign that we may be nearing the peak of the investment cycle.
The amount of seed stage capital available has increased more than the amount of startups pushing up valuations, especially for those that somehow become hot (which at the seed stage is not always correlated with actual traction).
This is reflected in the type of deals, we are seeing as angel investors at the seed stage.
- 2006-2010: Priced rounds at $3-5 million pre-money for startups that are live, with clear unit economics and a modicum of traction (say $25k per month in revenues) — like my 2006 investment in Brightroll at a $4 million valuation.
- 2011: Notes with a 20% discount on the series A and a $4-6 million cap for startups that are live with a bit of traction.
- 2012-2013: Notes with a 20% discount on the series A and a $4-12 million cap, though a number of startups are raising on notes without discounts to the series A or on uncapped notes often on Powerpoints or with no traction and no pre-defined business model.
- 2014-2015: Notes with a 20% discount to the series A and a $8-12 million cap with a cool product, but no traction and often no pre-defined business model.
I am glad that uncapped notes that peaked in 2013 seem to be mostly on their way out. They were the reason we only made 20 investments in 2013 vs. 41 in 2014. However, valuations of seed stage startups with limited traction out of Y Combinator have dramatically increased to $8-12 million.
It is surreal to observe investors with no technology experience commit millions in startups after a 2 minute pitch at Y Combinator demo days. The YC demo day non-withstanding, we are not in a bubble yet.
Having lived through the bubble, I remember clearly companies with no revenues going public and being worth billions, if not tens of billions of dollars. Today’s top companies like Uber and Airbnb may appear expensive, but they have billions in revenues, are growing extremely rapidly (they are some of the fastest growing companies in history from a revenue perspective) and have real business models.
As global interest rates are at record lows, people are yield chasing. As the tech sector is one of the engines of growth and wealth creation it’s experiencing what Henry Blodget defines as a boom.
Despite Frothiness At The Earliest Stages, Later Stage Opportunities Abound
While there has been seed stage inflation, it only appears ridiculous for YC companies. The valuation of seed stage companies out of Techstars, 500 Startups or entrepreneur-led are more reasonable, albeit significantly higher than 5-10 years ago.
This is by no means a criticism of YC. They select amazing entrepreneurs who build amazing companies many of which we end up backing either out of YC or at later stages – especially if they are in categories where we feel we can bring a lot of value.
We are not in a bubble yet.
At the same time venture firms are moving to later stages. Many of the firms that used to raise $100-400 million funds to write $4-8 million Series A checks have now raised $500+ million funds and sometimes $1+ billion funds. They are realizing that they need to invest larger checks, pushing them naturally to later stages.
This is creating lots of competition for later stage deals and allowing breakout seed companies to bypass the traditional Series A completely and raise large rounds at what used to be Series B valuations. However, many companies that do well, but not extraordinarily well have a hard time raising Series A money given that you have many more seed fund startups chasing fewer Series A dollars.
Large seed extensions have now become common as well as Series A rounds led by lesser known firms. Rather than investing in a team and product with no traction in a note with a $10-12 million cap, we now often wait 6-12 months for the company to be doing $150 – $500k / month in gross sales and join the seed extension or series A which ends up being priced at $12-20 million – a small premium we are more than happy to pay given that the business is now more proven.
Entrepreneurs would do well to remember that 99% of startups sell for less than $30 million, many for less than $10 million.
We will also pay up for breakout companies. We remain unit-economics driven and price sensitive, but will bend that price sensitivity rule if the company is growing by leaps and bounds and we can reasonably expect it to grow into its valuation – especially with the capital that it is raising.
Entrepreneurs would do well to remember that 99% of startups sell for less than $30 million, many for less than $10 million. Entrepreneurs think that raising money at a high valuation or with a high cap is a badge of honor, but raising money at a high valuation also prices you out of exits and makes it harder to raise follow-on capital.
Companies Are Staying Private Longer
Companies used to go public once they were worth a few hundred million dollars.
IPO Market Capitalization:
- Microsoft (1986): $500 million
- Yahoo (1996): $850 million
- Amazon (1997): $440 million
If anything Apple’s market capitalization of $1.78 billion at IPO in 1980 was the exception. These days the very best companies stay private much longer. Facebook went public at a $100 billion valuation in 2012, 8 years after it was created. Alibaba Group went public in 2014 at a $225 billion valuation, 15 years after its creation.
According to the NVCA, the average time for a venture-backed company to IPO has gone from 3.1 years in 2000 to 7.4 years in 2013. The very best companies like Uber and Airbnb are raising money at tens of billions of dollars in valuation to stay private longer. If anything the companies that are going public at $1 billion valuations like Box seem to be the ones that have no financing alternatives.
As a result there are more private companies worth $1 billion or more than ever before.
This makes eminent sense. The explicit and implicit costs of going public have increased dramatically. As an Internet entrepreneur I used to dream of taking my company public. No longer!
- The regulatory and compliance burdens have increased dramatically especially since the the Sarbanes-Oxley Act (“SOX”) was passed in 2002. It adds layers of bureaucracy, time, and costs which makes it harder to “move fast and break things.”
- The process for going public is painful and extremely distracting.
- Analyst coverage and liquidity for companies worth less than $2 billion is limited.
- You have to share more information about your strategy that your private competitors can take advantage of.
- The need to “hit the numbers” makes it hard to experiment with new business models or to cannibalize your own business even if it’s the logical business decision.
At the same time, the cost of staying private longer have decreased dramatically:
- There are more sources of capital to late stage companies than ever before. Traditional VCs have raised large funds forcing them to invest at later stages. Non-traditional actors like hedge funds and even mutual funds are also investing in late stage private companies.
- Investors are offering founders and employees partial liquidity either in financing rounds or through platforms like SharesPost (http://sharespost.com/ ) and Equidate (https://www.equidateinc.com/ ).
Historically the arrival of non-traditional actors has been the harbinger that we are near the peak of a bubble. However, this time may actually be different. Public market actors feel they must enter the private market because the value that used to accrue to public investors (e.g.; Microsoft’s increase in value from $500 million to $336 billion) is now accruing to private investors. Public investors in Facebook only saw a 2.2x return from $100 billion to $220 billion. Private investors at every stage got the vast majority of the upside.
Unless there are major changes in the rules for going public, this trend seems here to stay.
Global Macroeconomic And Political Factors Mean More Attention To US Companies
Beyond a rebalancing of our US investments from NY to San Francisco and Silicon Valley, we changed our global investment mix to focus much more in the US. Until 2012, only 48% of our investments were in the US. France, Brazil, the UK and Russia combined accounted for 36% of our investments.
However in 2014, 70% of our investments were in the US. We were only reasonably active in Germany (15% of the investments) and merely opportunistic in other countries.
This change was very deliberate. We observed the economic and political mistakes that various countries were making and decided to lower our involvement there:
- Russia squandered its opportunity to reform its economy while oil prices were high, allowed oligarchs to plunder its economy and entered in a futile conflict over Ukraine, making it all but impossible to raise venture money from non-Russian investors there.
- Brazil was in a perfect position to establish itself as one of the growth engines of the world. Its Bolsa Familia increased general welfare, its natural resources were in high demand, especially from China, it found huge offshore oil reserves, and inflation had finally come under control allowing interest rates to be cut. Sadly, it too squandered its opportunity to reform while the going was good.Nationalism around natural resources and local production rules led to huge costs for Petrobas – which was also used as the country’s piggybank. The government kept rates too low too long, reigniting inflation. Brazil squandered its opportunity to tackle the “custo-Brazil” – an extraordinary tax on productivity because of byzantine regulations and taxes – not to mention prohibitive tariffs. While the long term prospects are still good, from a comparative advantage perspective Brazil is much less appealing than it was a 5 years ago.
- France spent most of the last 3 years sending counterproductive messages with its 75% tax rate, anti-Uber and Airbnb laws and blocking the sale of DailyMotion.
- Europe in general has been stagnating. Many countries have entered deflation and politicians and policy makers are generally making things worse by treating Greece’s fundamental solvency issue as a cash flow issue. Pushing banks to further lend to Greece will only worsen the inevitable default. Europe as a whole has not tackled its banks’ bad debt intelligently. They pursued the Japanese strategy of letting zombie banks earn their way to solvency, rather than separating the good banks from the bad banks and the good assets from the bad, as the US did more effectively. As a result Europe as a whole has not deleveraged much and has much worse growth prospects.
By contrast, the US has once again become the engine of the world economy. The US has benefited from decreases in manufacturing costs brought about by the fracking and shale oil revolution, productivity increases driven by the technology sector, and increases in spending by corporations and households as their balance sheets have been repaired,
The US startup ecosystem is more robust than ever.
An Internet ecosystem has the following components:
- Venture Capitalists
- Private Equity Firms
- Exits through M&A or IPO
The US already benefited from the strength of the fully fledged Silicon Valley Internet ecosystem. Capital is available for companies of every size and exits happen at every point in the life of a company.
In most countries there are entrepreneurs and angels, but a real lack of Series A & B capital. American investors find you again once you cross $100 million in value, but getting the capital to get there is difficult. At the same time, exits are often limited to companies that become large enough that they attract American acquirers or can go public. By definition this only happens to a small subset of startups.
Only Beijing and Berlin have reasonably robust ecosystems outside of the US. It’s also why we focused our investments in Germany and large markets like Brazil where the domestic markets are large enough that the companies can reach $100+ million in value.
In addition to the macro-economic tailwinds pushing the US, the recent evolution of the Internet market has made the American startup ecosystem more robust than ever before:
- The Bay Area’s center of gravity has shifted from Silicon Valley to San Francisco.
- New York has emerged as the second largest ecosystem with a leadership position in fashion, ad tech, fin tech and the maker movement.
- Amazing startups are also coming out of LA and other cities.
- More people are pursuing the entrepreneurial path than ever before.
- There are more angels than ever before facilitated both by the thousands of newly minted millionaires from the various tech IPOs and Angel.co and FundersClub.
- There is more late stage capital available than ever before.
- Contrarily to what Mark Cuban recently announced, there are more exits than ever before with even failed companies getting acqui-hired because of the tightness of the labor market, especially for tech talent.