You can see from the chart below that the share prices of high-profile internet companies Facebook, Groupon, and Zynga are down 48-60 per cent over the last three months.
This comes on top of a lot of other negative news, including leading investors selling shares in the companies above at minimal profits, and CalPERS, traditionally one of the largest investors in venture capital, announcing that they have made a terrible 0.0 per cent return on venture over the last ten years.
As a result, commentators like Alan Patrick are asking whether we are seeing the end of Silicon Valley as we know it. I think that is an over-reaction. Here’s why.
Firstly, the fundamentals for start-ups are stronger than ever: innovation is still required, the cost of innovation continues to fall, the pace of change continues to increase, and the best people increasingly want to work in start-ups.
Secondly, many of the problems are limited to one aspect of the start-up ecosystem: late-stage funding for some consumer internet companies. LinkedIn, and numerous SaaS companies, are still doing fine on the public markets.
That said, I think the problems indicated by the graphs above are very real. The reality is that we have been dealing with a market failure to provide liquidity to investors in late-stage companies for most of the time since the internet bubble burst in March 2000.
M&A has existed at a reasonable level for much of that period, but IPOs have been thin on the ground, and while small funds can make a decent return focusing on M&A, larger funds need the higher valuations you get from public markets to make their models work. This is one of the reasons that CalPERS returns have been so poor for the last ten years.
For the last couple of years, it looked like specialist late-stage funds like DST, private exchanges like Second Market, and latterly dedicated growth funds from traditional VCs like Kleiner Perkins were stepping into the void. These funders were providing liquidity to early investors and additional capital for growth, just like the IPO markets used to. The market thought it had found a solution to its failure.
The investment thesis for these specialist late-stage investors was to pay high valuations and then drive share price appreciation via revenue growth and hype, leading to an IPO. That worked for a while, but following recent losses for IPO investors I suspect those days are over.
Pinterest is a great company and a great service, and I’ve written about them admiringly in the past, but now they have become interesting as a case study of a deal that made sense a few months ago, but would be harder to understand now. They are rumoured to have recently rasied $100 million at a $1.5 billion valuation. That worked when comparable companies like Groupon and Zynga were worth $10 billion+, but looks chunky now they are at $2-3 billion.
With its $1.5 billion price tag, Pinterest will have a lot of work to do to get to the point where they can go public and deliver a venture return to their recent investors, and they have a valuation now which puts them out of reach for acquisition for all but a handful of massive tech companies.
So these sorts of deals will dry up, and we will be back to the situation we had before DST stepped onto the scene.
Fortunately, capitalism is a resilient beast and I’m sure we will find a new solution to the market failure. This time round, I think it might be that a different type of investor steps into the IPO void, one that is focused on the fundamentals of profits and cash flow as the drivers of value.
That will mean lower exit valuations for successful companies and less cash around to fund acqui-hires – which in turn will mean that angels and venture investors will need to reduce their valuations if they are to make a profit on their investments, probably leading to smaller rounds and smaller funds.
But this doesn’t mean that the ecosystem is broken. It will still be possible for entrepreneurs and their investors to make good money. But it will take a little longer, be a little harder and the payout will be a little less.
It may be a painful transition, but the tech start-up ecosystem can and must remain an important and thriving part of the global economy.