Tuesday, March 4, 2008

Stock Market Slide Effecting Start Up Valuations

Early stage VCs typically say that the ebbs and flows of the stock market don't effect the valuations they pay in start up financings. That may be true. At the formation stage, when a start up is little more than a business plan and a few dedicated engineers, there are a host of other factors that influence valuations more so than PE multiples of public companies. VCs tend to put greater weight on the potential market size of the product being built, the reputations of the founders and the number of existing competitors than they do on swings (positive or negative) in the NASDAQ index.

So to some extent, entrepreneurs and VCs can comfortably ignore the chaos of currency fluctuations, interest rate changes and other macro finanicial shifts. The operative phase here is 'to some extent'. You see, unless a company only plans on raising one early stage funding round, it must eventually seek capital from a different cast of characters: the later stage or 'growth capital' providers. And guess what? These firms most definitely do look at public stock market valuations as a measure of how to price a private company.

Just six months ago, many companies in traditional venture backed industries (enterprise networking, wireless and storage to name a few) were trading at attractive PE and revenue multiples. For instance, in the enterprise networking space, companies like Riverbed, Aruba and Isilon were trading at better than 10 times sales. With valuations in these sectors now down 50% to 75% from their highs, later stage funds are becoming much more careful when it comes to valuing private businesses. In fact, if a VC backed company raised a Series B or C round in the past year, there is a good chance the NEXT round will be flat or possibly below the previous financing. The justification for these more conservative valuations? NASDAQ. Or rather, what has happened to tech heavy NASDAQ in the past few months. A growth fund wants to invest in a company that it can reasonably see going public in the next 12 to 24 months. No fund wants to face a situation in which the last private round valuation is ABOVE the expected IPO filing range. So what are they doing? These funds are being much more conservative in how they value the companies they invest in. And keep in mind, in January and February 2008, over 2 times the number of new issues were pulled than successfully completed their IPOs. So not only are valutions dropping but the bar to go public is being raised dramatically.

The tightening of valuations for later stage financings (particulary the mezzanine or last round before going public) is having a cascading effect on the pricing for earlier rounds. Whereas just a few months ago it was possible to get a 3X step up in valuation from the Series A to the Series B round, it is now more likely that the step up will be 1 to 1.5X.

Two observations fall out of this. First, as long as the public markets are under pressure, expect venture valuations to hold or decline, particularly in later stage financings. Second, as a CEO or founder, take a hard look at what you are planning on achieving with the most recent capital you raised. If the business achieves everything you promised to your most recent investor, does that justify a substantial increase in the valuation of the business when it comes time to raise the next round? If you have doubts, take another look at where the capital is being spent. This is what Clearstone is doing with its portfolio companies. Its a dynamic world and even the best laid plans have to be questioned.

No comments: