AGILEVC My idle thoughts on tech startups

November 21, 2010

Investors, both VCs and angels, seem to be doing some crazy things of late.  What started as a frenzy in the seed spectrum of the market earlier this year (by angels, micro VCs, and large VCs) seems to have spread to later stages of the startup investing world.

Bill Gurley talked about this publicly via twitter “VCs/Angels are behaving like its 1999 – crazy entries (without the crazy exits).”  Fred Wilson had his “Storm Clouds” post.  But if you speak privately with other thoughtful, well-connected VCs and angels you often hear much the same sentiment.  Valuations for the “hottest” startups are blowing up, and not just at the seed stage.  VCs and angels are doing unnatural things to invest in a small cadre of companies with momentum.  Top tier investors are going farther afield from their home base, in recognition of a world where innovation is distributed and software-based startups can be capital efficient at the early stages.

So there’s plenty of fodder for those who want to make the “bubble” case.  But what if it’s a “boom” rather than a bubble, as John Doerr suggests?  What if much of the enthusiasm for software based, internet enabled businesses is well founded, and after a global economic crisis, upheaval in the VC industry, a challenging IPO market and the rest… we’re actually on the cusp of very exciting times?  Let me make the case for a boom in this sector:

1) Impending Blockbuster IPOs & Exits - Assume that in the next 12 months one or more of the following companies has a blockbuster, multi-billion dollar exit:  Zynga, LinkedIn, Groupon, Twitter, Facebook.  Assume it comes via IPO, though it’s conceivable it would be via acquisition or possibly IPO and then subsequent acquisition.  I think Twitter and Facebook are the least likely of the group to go public in the near term, though for different reasons.  But for better or worse those five companies have been the most anticipated IPO candidates in this sector for awhile, and arguably have been in a “quasi-public” state with fairly liquid secondary markets in their shares.

2) Secondary Wave of Possible IPOs - While they may not get the same spotlight as the five companies in #1, there are a bunch of exciting internet businesses poised to become public companies in the near to intermediate future.  These include some like Kayak and Everyday Health which have already filed S-1s, but also eHarmony, Gilt Group, Art.com, Brightcove, Tremor Networks, Pandora, and others.  All of these companies are at or are rapidly approaching most milestones appropriate for a standalone public company.  And the recent gloom about the IPO market may actually run counter to the facts on the ground as Bill Gurley suggests.

3) Cash-Laden, Growth-Hungry Acquirers - All the usual acquirers have billions in cash on their balance sheets and a demonstrable interest in acquiring businesses for growth and innovation.  There are plenty of very small “talent acquisitions” (<$50m) of course or even small-medium tuck-in acquisitions.  But Google, Amazon, and Apple have all closed 9 and even 10 figure acquisitions relatively recently (AdMob, Quattro, Slide, Zappos) and gotten very close on others (Yelp, Vente Privee, et al). I think some historical acquirers like Yahoo and AOL are obviously less active, at least with very large deals, but there are several other potential buyers both obvious (Microsoft, eBay) and less obvious (e.g. Cisco).

4) Long-Anticipated VC Correction Happening - Forget all the brouhaha about “Is the VC model broken?” or the false conflict between “super angels vs. VCs” or even a “super angel bubble”.  These memes are great generators of page views, but frequently provide only modest insight on the mid-long term future.  Most smart, thoughtful people have argued that over the last decade or so there have been too many VCs with too much capital which led to poor returns for the industry overall and would eventually result in a correction.  The upheaval takes a long time because of long fund life cycles, the J-curve, and other dynamics.

But it’s indisputably happening at this point.  The VC industry consistently raised $20-30B+ for most of the past decade, but 2009 was roughly $15B and 2010 is shaping up to be even less than that ($9B thru Q3 2010 – PDF link).  The NVCA’s press release title was spot on “Fewer Firms Raising Smaller Funds Remains the Trend” and everybody’s prediction of a VC industry getting 40-50% smaller seems true. The shrinkage isn’t just in assets under management (AUM), but also in the number of firms.  The number of new firms has shrunk by nearly a half but what’s less appreciated is the number of existing firms raising new funds has dropped by a similar percentage.  Regardless of whether you believe the pendulum has swung too far, the long anticipated VC industry shakeout has happened which should actually bode well for the future vigor of the business.

5) Today’s Crazy Valuation is Often Tomorrow’s Brilliant Bet - Some crazy valuations are just that… seemingly unfounded with the benefit of hindsight.  But occasionally they’re risky, high-beta bets that pay off handsomely for investors that were either prescient, lucky, or both.  In 2006 Greylock invested in Facebook at a $500M valuation and lots of people scoffed, either publicly or privately.  I personally thought Google’s 2004 IPO price of $85/share was a weak long term, risk-adjusted investment (my mother-in-law never lets me forget this since I discouraged her from participating in the dutch auction IPO).  Undoubtedly some of the crazy stuff today will be just that, but I’m equally certain some seemingly irrational exuberance will in fact turn out to be great investments.

I don’t deny that some irrational behavior may exist in the startup ecosystem, and the echo chamber / hype machine is always effective at shining the spotlight on outlying situations.  To be clear I’m not predicting a 1999 type frenzy or anything and while the process involves pain for some, truly overheated markets inevitably correct themselves.  But I think there’s as much to be said for the “boom” scenario as there is for the pessimistic case.