RIP Summer

At some point things had to come back to reality. Even if only a little.

 After a multi-year bull cycle that raised the prices of domestic equities to levels that made value-focused investors squirm, the U.S. markets are suffering from a stiff correction, dropping in partial step with international shares and other assets.

It’s a global cold, and everyone is sneezing.

Apple opened dramatically lower this morning, mirroring broad index declines. Twitter dropped a few points in regular hours, and more after, trading below its IPO price. Box has fallen even more, also trading below its IPO benchmark.

Those three firms — the largest tech company by value, a mid-sized social shop, and one of best-known SaaS companies — represent different sectors, if you will, of the technology industry. Notably, their value declines are in keeping with their scale. Box fell the most today, Twitter took second (counting after-hours), and Apple’s final drop is the smallest.

Let’s make a number of broad claims, employing those three companies as examples; we could select other firms, but as we are all very comfortable with the financials of this trio, we rest on firm ground.

A Correction Is Not Surprising

Signs that things weren’t great in the global economy have been strident for some time. Dropping markets, smoked commodities, falling shipping rates, slowing Chinese macro growth, a Eurozone stuck in neutral, Fed uncertainty, lackluster domestic wage growth, and slipping profit expansion among American firms lashed to high public multiples were all warnings. They are different sorts of warnings, but red lights all the same.

Also, happening just about a year ago was a conversation inside of technology itself, arguing that the current financing environment is out of whack. Gurley, Andreessen and Wilson also spoke up. TechCrunch wrote about risk, bubbles and off valuations incessantly.

Despite plenty of sturm und drang, nothing much changed. Folks nodded their heads and then bolstered their cash burn and non-GAAP losses.

A key question today is what the current decline in asset values is¹. Is it a formal correction that will persist, or is it merely a drop brought on by global conditions that are hampering American markets?

This brings us back to value. Why do we care about the price of public companies? Because in tech investing, things work backwards. Venture capital is the NASDAQ on steroids in the private sector, which directly links venture capital returns to how rich public valuations are.

There is lag in that relationship, but if public shareholders repudiate IPO shares, it casts a pall over other private valuations. So who is wrong? The investing groups or the venture shops with an interest in seeing pre-money figures on their portfolio companies continue to skyrocket? I’m more skeptical than enthusiastic.

If Twitter is trading below its IPO price, and is now worth less than the dollar amount that Snapchat wanted to raise capital at earlier this year while enjoying a massive revenue multiple, you have to wonder if the public is too hard on Twitter or if private kids are too bullish on Snapchat. The same tension exists between Box’s public valuation and Dropbox’s most recent private number. Who is off base?

But if social and SaaS are struggling in the public markets, then companies in those categories could have a hard time hitting go on an IPO, which means less liquidity, less return, and potentially a round of lower valuation growth.

That things are colder than they were is not a surprise. The scale, and timing, of our current retrenchment are notable for scale, but not for existence.

Startups That Are Still Burning Too Much Were Warned

Returning to our three venture capitalists, they did a fine job last year telling young companies that it might be a good time to lose less money. But those pronouncements were overshadowed by massive new venture funds, a quick investment cadence, and increasing valuations. Who wants to listen to people who are worried when there is a happy person standing next to them with a checkbook?

I’ve recently asked a number of venture capitalists if they are seeing LPs change their asset allocation away from venture. Nope. And that means we could still see a few decent cycles of new capital flow into startups.

But, as I wrote last year, in the middle of the startup Burn Rate Debate:

As long as interest rates remain low, and the public markets remain near record highs, an appetite for larger returns will manifest itself in large amounts of capital accessible to. So the game, for now, is still afoot.

The flip of that, if you want to stare at the market from the top, is simply that piles of public money are helping to keep private money stupid. Amplifying the above is the fact that large tech companies are cash-rich at the moment, boosting sale prices for companies both strong and weak. That money often ends up back in the cycle, and then it’s once more around the sun.

Things are different, a little, but quite a lot of the core strength that we’ve seen in terms of inputs that potentially bolster valuations are still in place. You can’t kill that momentum with a few days of public declines. Those same declines, however, could be the start of a momentum shift.

If This Is A Correction, Private Valuations Have To Give (Some)

If investors suddenly decide that the value of future earnings of technology companies will be lower than previously expected, the value of all tech shops declines.

There has been, I think, reticence among some late-stage startups to delay an IPO until their internal metrics better match the valuation that they hope to command from the public; if you let your valuation accelerate outside of your metrics, you can always work for a year and then hit go when the math adds up.

But if valuations in the public sphere are shrinking, that boosts the discrepancy between what the general populace will pay for your equity and what you last sold it at to private kids. That could mean a longer ramp to parity, the need for additional private capital and, yes, the potential for a down round.

God forbid.

Let’s be clear: Valuations are not just high, they are in some cases humorous in a sad way. As public markets hit the brakes, it can’t help but impact how younger firms are valued.

Current VC Sentiment

If you hang out with venture capitalists — and I do not recommend it — ask them how they plan, and shape their investment patterns around macro conditions, both current, and future. The standard answer in my experience is that the venture capitalist in question will hem, haw and aww shucks you, and then say that if they could time the markets they would work for a hedge fund, and not a venture company.

It’s a lackluster answer, but one that has an odd bit of humility: VCs really don’t know what is coming. Think about how long ago Gurley, Wilson and Andreessen rang the bell; it’s only now that we’re really seeing a sharp enough decline to cause panic inside the industry. And those are three of the smartest VCs.

But, given LP flow, large paper returns, and newly inflated funds, there is little motive right now to dramatically change investing theses. Venture capitalists, after all, are often overly paid lemmings.

If This Drop Scares You, You Are Probably Overexposed

It could get worse. Markets may continue to fall. China could get itself into a full-on credit crunch. That would harm global GDP growth for years, slowing demand for trade and the precise sort of animal spirits that the tech industry depends on to grow companies at far-higher rates than larger economic structures.

For now, however, may your 401k live on, and keep in mind: At least you didn’t get fired today.

¹Insert Clinton joke here.