BLOG STARTUPS, VENTURE AND THE TECH BUSINESS

October 1 2014
by Todd Hixon

Will You Buy Your Healthcare At Walmart?

[This post first appeared at blogs.forbes.com/toddhixon on September 26, 2014.]

Then it’s best not to build your house on it. Silicon Valley sure looks like a bubble to me, and many others think so too. While these are heady times, it’s actually very difficult to start new investments. Some back-to-basics thinking is the best way to mitigate the risk.

I spent several days at a conference in Silicon Valley recently and then visited venture capital friends on Sand Hill Road. The venture capital market there is dramatically different from the rest of the U.S., even New York, which is having a good run. Here are some of the things I heard:

• Entrepreneurs across the country believe it’s easiest to raise money in Silicon Valley because there is so much money there, and they can raise more money on terms that are better for entrepreneurs.

• Early investors in Silicon Valley buy convertible notes that are un-priced (i.e., just convert into the next equity round at a small price discount) or have a high conversion value cap because those are the “market” terms you have to take to get into hot deals. Investors often have minimal rights: no board seat, no approval rights, etc.

• “A” rounds are occurring at valuations of $20 – $30 million post-money, raising $8-$15 million, with the lead investor writing a check that often approaches $10 million (more).

• To get your Series B term sheet accepted by a hot company, you need to at least double the Series A valuation, to $50 – $60 million pre-money, hence close to $100 million post-money value.

• A handful of venture capital firms have raised billion dollar mega-funds.

• At Series C, valuations often climb to $200 – $300 million. The mega-funds are writing $30+ million checks in these rounds. Venture firms with $300+ million funds and good names feel buffeted by the wakes of the handful of firms with magic names and a billion dollars to spend.

• Hedge funds, growth funds, and private/public crossover investors are piling into later rounds at valuations in the billions, such as recent rounds raised by Uber and Box.

• The major internet companies are growing in number and battling for market share and pole position in the next trend: mobile, virtual reality, flash messaging, whatever it will be. This has produced breath-taking exits for a small group of mostly Silicon Valley start-ups these firms deem strategic, e.g., WhatsApp or Oculus Rift.

• The IPO market is back: VC trade pubs gush about “unicorns” (deals valued above $1 billion, which were called “platinum Frisbees” in the last bubble) and recently “purple unicorns”: deals valued above $10 billion. And then there was Alibaba, the mother of all tech IPOs.

• The driveway at Rosewood, the boutique hotel at the top of Sand Hill Road, is full of exotic cars, and the Rosewood bar is said to be an exotic scene of another kind after hours [this is hearsay: I was there for lunch].

I heard a few discordant notes as well. Despite flush cash balances, many corporate M&A buyers are thought to be holding back because valuations are too high. One VC commented: “There will be more M&A exits when the values come down.”

At the Health 2.0 conference, which I attended, there was much moxie on display, including a digital health wearables fashion show complete with a runway and a custom music mix. I heard comments, however, that digital health investors are starting to see a lot of me-too offerings: if you closed your eyes and walked 100 feet, you’d bump into three companies selling systems to reduce hospital re-admissions.

Many VCs are wondering, how do you invest into this market with a decent chance of success? If you are chasing the companies that have visibly achieved “escape velocity” in their markets, you are competing with the great names and greater check books. Only a handful can succeed in that game. And then you pay a price based on perfection and bet on continuation of aggressive growth financings and a hot IPO market.

If you play at the seed level, you compete with the host of angels, accept weak terms, and invest in companies in which entrepreneurs may be on their own because seed investors often can’t help, don’t spend the time, or lack governance levers when the going gets tough. And occasionally the big funds reach down and take over an early financing with a big check at a high price, squeezing other investors out. One VC blogger calls this a “piggy round”.

Burn rates are running $500k to $1 million per month and up, in many cases (more). This presumes the ability to keep financing on favorable terms. If not, the blood quickly gets ankle-deep. This market dynamic looks delicate to me. While the Internet continues to grow and entrepreneurs keep finding new opportunities, the sources of money fueling much of the boom are fickle. The scope of the hot market segments is narrow: largely confined to Silicon Valley and a half-dozen sectors. If the end comes fast, many companies will quickly be in mortal jeopardy: burn rates, valuations, and capital structures will be crushed.

What to do? It’s almost impossible for investors to step off of a rapidly rising escalator. As one put it: “There’s no difference between too soon and wrong.” But one can hope for the best and also plan for the worst. The best protection from a bubble collapse is getting to profitability: actually booking profit or having the option to pull back investment and operate profitably at a slower growth rate. Profitable companies can sustain themselves and grow at every stage of the financial market cycle.

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