Startup Valuations: Strong Like Bull
Startup valuations are going up. The ‘series-A crunch’ and imminent doomsday prognosticators can let it go. I can’t argue that valuations aren’t 'high.’ They are. But all any investor should care about now is where they go from here. And my math says they’re going higher because of asset reallocation, uninvested funds, and market under-representation of new digital media companies. These things comprise such a big theme that (almost) nothing else matters.
Asset reallocation….
Corporations (be they people or not) and people (be they corporations or not) are hoarding cash. In my opinion, recent reports of 'The Myth of Cash on the Sidelines’ are, well, myths. Nominally, toward the end of last year, nonfarm nonfinancial corporate businesses held $2.11 trillion in liquid assets. Moreover, at these businesses the ratio of liquid assets as a percentage of total assets has turned up significantly over the last year reaching the upper end of its 30-year range. Individuals have built cash hoards too. And asset reallocation is a way more influential determinant than anything so let’s look at where this money could go….[[MORE]]
It could stay in cash, in which there is, by definition, no (nominal) yield. And what with the concern about debt, the euro, cheap Asian and South American currencies, etc. it is unlikely that people will want to store value here.
There is no yield in fixed income. The current federal funds target rate is 0-0.25% and there is little to no indication that the Fed will increase rates any time soon. So keeping money in fixed income doesn’t seem much better than keeping money in cash.
Real estate isn’t in much better favor today than it was a few years ago and countless 'experts’ tell us we have not yet hit bottom. (Though considering the negativity it is probably the right time to allocate to real estate.)
Commodities have had an almost unprecedented run (prediction: Glenn Beck adds personal petroleum oil exchange commercials to his gold repertoire). So it’s a chasing game now with the 'smarter’ money locking in profits and looking for return elsewhere.
That leaves equities. And in particular, growth equities, which have been out of favor for about a decade while value stocks have ruled the roost. Despite being overdue for a new look, the biggest issue I see with (growth) equities is that even if we assume an average annual return of 10%+ in equities (the annual average during just about any 30 year period), it should be more than clear that volatility (i.e., risk) has increased (have you been on the market roller coast over the last year or so?) So if we assume that the 10%+ average return holds (though it may not), with higher risk/volatility the risk/return ratio is relatively inferior.
In search of… Beta.
So where’s the juice? Private growth companies. This is one of the only places to find fast growing, revenue generating companies with crazy potential for profit if they’re not generating oodles of cash already. Clearly this has not gone unnoticed as valuations at nearly every stage of the cycle (from angel to series A, B, C+) have expanded. But large pools of uninvested funds, reallocation, and under-representation in the market are trends that will continue to drive valuations higher until the supply/demand imbalance of cash and the companies that want it evens out.
Uninvested funds….
My extremely informal poll of venture capitalists suggests that they have lots of dry powder. Those with existing funds have only invested 40-50% of their capital. Again, this is hardly a scientific finding, but I’ve heard lots of venture capitalists 'complain’ about high valuations. When on earth do investors complain of high valuations? When they’re not invested. That’s when. And let’s not forget about all of the new venture funds being raised; e.g., Andreessen Horowitz just raised $1.5 billion (with a 'b’), Union Square Ventures is raising or has raised a new fund, IA Ventures, etc. Mo money, mo valuations. This is all in addition to the investment banks that are raising venture capital funds and/or creating vehicles for their clients to gain access to private growth companies (I’m talking about you Goldman Sachs, Morgan Stanley, JP Morgan, et al.) So demand for private company shares should be evident not only in their high prices and not only in the new venture funds created to invest in them, but also by individuals all but begging for access to deals.
Under-representation….
Yes, LinkedIn, Zynga, Groupon, etc. have already reached the public markets and Facebook will be there shortly. But even Facebook’s multi billion dollar raise will not satiate current demand. And, perhaps more importantly, this emerging group of companies (social/mobile/cloud) is under-represented in the market, especially compared to what their impact will be on economic activity.
Let’s put it in perspective…. Today, what I would consider 'pure Internet companies’ represent ~13% of the enterprise value of the NASDAQ 100 (which is already tech heavy and I’m talking pure Internet here). When the dotcom bubble began, by default this figure was 0%. So over the past decade investors allocated 13 percentage points of value to companies representing the foundation for the new/Internet economy. Today, the aggregate enterprise value of public pure social/mobile/cloud companies would be ~1% of the NASDAQ 100 (and I’m being very generous with the term 'pure social/mobile/cloud’ here; i.e., it’s really considerably less than 1%). Even if we include Facebook that number doesn’t get past 5%. And none of these companies are in the NDX right now as far as I know. (My math is here.) If you buy into the thesis that the move to social/mobile/cloud computing is as big or bigger than the move to web computing was a decade or so ago, then the public markets should ultimately reflect this in their indicies. Gotta represent.
You make the most money at the top and the bottom….
Ed Hajim, former Chairman/CEO of Furman Selz and later ING Aeltus and the first portfolio manager I ever worked for (and, well, the Chairman/CEO of the first bank that ever paid me) used to tell me you make the most amount of money at the top (the blow off) and the bottom (the crash). I don’t think we’ve seen the blow off yet and that means that we’ve got some more craziness to come, which is good. Yay. In fact, I’ve said for a while now that the question of whether we are or are not in a bubble is not relevant. Rather, we should ask is it 1995 or 1999? That said, 1995 and 1999 (and a few months of 2000) were quite good so I think we’re well positioned either way. Yay again.
Ultimately, the pendulum will swing in the other direction when capital is (over) allocated, funds are (over) invested, and social/mobile/cloud companies are (over) represented. And there are plenty who have been making that call already - in the social/mobile/cloud space as well as the market overall. Nouriel Roubini, Dr. Doom, remains negative and garners (well deserved) respect for calling the housing market collapse and consequent financial disaster a few years ago. But how many of you have heard of Elaine Garzarelli? Exactly. That’s her above (and her dog). She called the 1987 stock market crash (Black Monday). She stayed pretty negative too. At least Roubini throws better parties. Zing.