Making the System Work For Everyone

When I was young, my dad used to tell me that there was a proverb in Greek that went something along the lines of: “there is a special shame in taking the last morsel of food.” The lesson was an admonition about not being piggish, or maybe showing restraint, or perhaps being gracious. Deep down, though, I always suspected that it was just a ploy to put the last slice of pizza in the fridge so that he could enjoy a late-night snack after I’d gone to bed.

When I came into the venture business 16 years ago, somebody told me something similar. Even though I forget who said it, I’ll ascribe it to Henry McCance, in my mind the font of all wisdom I picked up during that period (“when venture works well, capital is expensive and time is cheap.”) He said, “it’s important to leave something on the table for the next guy – that way the whole system can work for everyone.”

I used to think about that statement a lot. Individuals are incentivized to maximize, although optimization works better for the system. It’s kind of a Tragedy of the Commons problem, right?

I’d forgotten about both sayings in the intervening years, but recalled them again a couple of years ago when I started seeing overfunded rounds at vanity valuations and other cap table shenanigans. The apotheosis of some of the worrying trends seemed to come about 18 months ago. Back then, it seemed that companies were able to raise cheap and easy money at inflated valuations based on perfect execution of their coming two-year plans.

So here we are, almost two years later and some companies have executed and others haven’t – that’s the risk of venture – and a lot of companies that raised then are looking to come back for fresh cash. There’s definitely money still sloshing around and the trainwreck some of us were worrying about seems to be less imminent, to everyone’s relief. Although, I do expect some tensions as the era of easy markups may yield to a time in which “flat is the new up.”

Indeed, every dollar demands a return, especially those of the final investor, whether that might be someone in the public markets or an acquirer. If they stop getting value, they may stop buying what we’re selling; it’s the classic boom-bust dynamic of IPO windows. The anemic number of tech IPOs last year suggests that maybe the outside world has gotten wise to the fact that we’re leaving less for the next guy. The always-awesome Beezer Clarkson wrote a great outlook post at the outset of this year that talked about some of the ways in which the exit markets had evolved: “The market went from valuing growth to looking for sustainable business metrics, which not all VC-backed companies felt that they had to get the valuations they wanted.”

Which of course reminds me of Josh Kopelman’s seminal 2012 post about the JOBS Act that noted the post-SarbOx change in public and private market value creation in the past compared to that of recent years. The topic is a nuanced one, but Josh reminds us that among ten pre-SarbOx tech bellwethers, public investors were able to capture about 97% of the ultimate value creation.  Now that’s leaving something on the table for the next guy! Maybe too much; I’m not sure we need to return to those levels and the markets (both pubic and private) have changed in some meaningful ways, but there’s a happy medium somewhere between that and the dreaded “down IPO.

For the Moment Mellow . . .

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Since I too often bellyache on these pages, I thought I’d share something I wrote for a quarterly letter at the end of last year.  Ironically, the poem I reference is called Temporary Well Being. Comments and feedback encouraged, just don’t harsh my mellow, as the kiddos say . . .

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Q4 Commentary:

A Kenneth Burke poem inscribed on a wall in New York’s Penn Station begins, “the pond is plenteous and the land is lush and having turned off the news, I am for the moment mellow . . .”

I’ve been thinking about this poem a lot recently, as Silicon Valley seems to be enjoying a sanguine moment. Although the tech world was consumed at the outset of the year by an unease that resulted from an investing pullback on the part of so-called Tourists – a cohort of large public market-focused investors who had become active in late stage private investing – the middle third of the year seems to have been marked buy a growing realization that the sky was not falling.   And by September, optimism engendered by a smattering of tech IPOs lifted spirits across the Valley.

Indeed, an uneasy truce between bulls and bears seems to have emerged as 2016 slouched to its conclusion. The headline of one of our favorite barometers, the Fenwick and West Venture Capital Survey, reported that, “valuation metrics were down modestly in the third quarter.” After all, the median round over round price increase among companies completing financings during the third quarter was 27%, down slightly from the second quarter’s 31%. While the Report noted that this was the lowest amount since Q4 of 2013, this rate of increase was right in line with the 10-year average calculated by the survey. Our conclusion, both from the data, as well as from our on the ground perspective, is that the entrepreneurial ecosystem seems relatively healthy; there are many great companies who are being rewarded by increased valuations for the progress they have made.

What has caused some consternation around the Bay Area, however, is the decline in mega-financings driven by the exit of the Tourists. The late-stage market, which had been defined by froth in recent years, has slowed. Financing used to be available to companies at levels that assumed perfect execution for the subsequent 18 to 24 months; there was a conceit that all of these companies would grow in to their valuations. Today, late stage investors are only paying for progress to date and acknowledging execution risk and uncertainty. As result, many venture capitalists to which we have spoken are suggesting to their companies that are fundraising to expect valuations that are 25 to 40% lower than they might have expected a mere 18 months ago.

This, of course, is good news for us. Buffet’s equation tells us that Opportunity equals Intrinsic Value minus Perception. As sentiment comes into line and folks acknowledge the reality of risk, prices should come down and our expected return should go up.

This new reality is being reflected in entrepreneur perceptions, as well. First Round Capital produces an annual survey of start-up founders and one of their typical questions is, “who has the power in fundraising negotiations?” In a 180° reversal of last years results, entrepreneurs this year’s survey said that power rests with investors by a two to one margin.

Of course, optimism is always empty without the prospect of healthy distributions. We are hopeful that the momentum of late 2016 will carry over into the new year and that both distributions and valuations will give us, the ultimate providers of the capital, reason for a continued excitement that we would have never thought possible at the outset of year.

As we look to 2017, the conclusion of that Kenneth Burke poem sums up our feelings nicely: “ . . . with my book in one hand and my drink in the other, what more could I want but fame, better health, and ten million dollars?”

 

In the Time of the Gatsbys

img_4393So this buddy of mine, Peter Stein, is one of the best hedge fund evaluators I know and I once asked him how he knew to steer far clear of Madoff?
“Sometimes, returns can be too good,” he replied sardonically.

But it’s never been that way in Silicon Valley, a sunny and magical land where risk-adjusted return is impossible to calculate since risk is perpetually dialed up to eleven.

And in a culture steeped in selling the impossible, sometimes things go a little too far, which reminds me of another thing Stein, a veteran of ‘80s Tokyo and ‘90s New York, once cautioned me about long-running bull markets:

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Secondhand Flowers

flowersOld O’Malley used to dispense sage advice from his stoop in Brooklyn. The smoke of cheap cigars and the cracking of the Yankee game on the transistor radio hung heavy in the humid night as O’Malley meted out wisdom like Aristotle under an olive tree. And one nugget that stuck with me through the years goes as follows: “never buy a girl secondhand flowers. The last girl may have enjoyed them, but your girl will just think of them as used up.”

So what does this have to do with investing? Recently, I was talking to someone about a company that was about to go public and they were lamenting the large discount to public comps implied by the bankers’ pricing guidance. Of course, IPO investors crave a first day pop, but the discount seemed to be bigger than they had seen lately. We wondered aloud why that might be? Lackluster aftermarket performance of last year’s IPOs? Higher perceived risk in the economy? Idiosyncratic risks of this company? And so on. This person also talked about how the bankers remarked that some private companies were pretty close to being overvalued relative to public companies, creating an inversion that would make any liquidity efforts tough.

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