Deals Gone WIld (aka "What Drives Massive Startup Valuations?")

A few months ago, I wrote a blog post on startup valuation that presented a table of normal or “typical” price ranges for startups depending on the sector and stage of development, among other things. You can view that post (and the valuation table) here.

But what about the outliers? What drives the sky-high valuations and manias we occasionally see around a deal? What about the deals we all envy and aspire to do?

In short, what creates valuations such as the $2B for LinkedIn, $2.1B to $3.7B for Twitter, $5.5B for Zynga, $6.4B to $7.8B for Groupon, and last but not least, the $42 to $70B for Facebook? (estimated ranges, based on recent secondary market trading).

While every deal is unique, here are three of the top startup valuation drivers of "deals gone wild": 

Founders who have done it before (ideally at a name-brand company). The premise here is that a proven jockey will figure out the best way to win the race. And while history is generally a decent predictor of future results, other success-determining factors probably come into play too. For example, ex-founders of “hot” startups often find it easier to attract top talent (e.g, FourSquare, Square, and Quora), which in turn draws in more top talent. In addition, seasoned founders have presumably gained much of the scar tissue and lessons learned from navigating companies to a successful exit the first time around. 

A leadership position in a winner-takes-all market. Some startup business models benefit from so-called “network effects,” which means that as the number of participants grows, the network becomes incrementally (or exponentially) more valuable to each new member. Social networks like Facebook and LinkedIn work this way, as do services like Groupon. The ultimate result is the creation of the Borg (for Star Trek fans) or a snowball rolling downhill (for non-Trekkies); in other words, an entity that sucks up all the customers in a market space as it gathers mass and momentum, and that produces a dominant new platform leader. In my view, this is the biggest driver of deals that go truly wild. 

Profitability from Day One. Some startup business models are, quite literally, profitable almost from the get go. Assuming the startup has achieved some baseline level of engagement, stickiness, and (ideally) viral growth, the investment bells go off the moment that ARPU > CPU; or, in simpler terms, each new customer brings in more revenue than it costs to acquire them. At that point, it becomes less about the business, and more about the opportunity to arbitrage that delta through increased marketing spend. In such cases, funding is a no-brainer, and it simply becomes a function of figuring out how large the company can grow, and how quickly capital can be pumped into it. The virtual goods space with its almost zero creation and transaction costs, and the online gaming space in general (especially those that feature low cost-to-create casual games like Zynga) fit this model.

Granted, there are typically many other factors at play when valuations skyrocket, such as general frothiness at the secondary markets, implied validation by a trusted party (such as the Goldman deal with Facebook), or a hot exit or IPO environment. But in my view, the three factors above are at the core of most hot deals, particularly in the Internet space.

What am I missing? When you put on your CSI hat and analyze the scene, what other causes of 'deals gone wild' do you see? What do you think drives huge startup valuations?

Tough Market for Entrepreneurs? VC Firms Are Having a Rough Go Of It As Well...

Venture capital investing is supposed to be a long-term investment play...venture funds generally have 7-10 year durations, over which time they invest the money raised from limited partners (e.g., teachers' pension funds, endowments, etc.).

In addition, most VCs will tell you their own time horizons for making investments in startups is pretty long... usually 5-7 years, as this has historically been the minimum amount of time it would take an early stage firm to reach IPO.

So why does it seem that the venture industry is almost totally synchronized and correlated with the U.S. economy and stock market? Shouldn't venture capital, with its lengthy and comfortable 5-10 year time horizons for investing, theoretically be almost counter-cyclical?

Wouldn't it make sense that venture investing might actually pick up in down times, since relative valuations would fall (and thus an investor could buy "more for his/her money")?

Theoretically, it should-- and in a purely rational market it would-- but that would ignore human psychology. In short, the "fear factor" goes all the way up and down the food chain. The public pension funds that put in the source money are looking at the state of the exit market (i.e., IPOs) as of today-- not what they are likely to be 5 years from now (and for the record, the IPO market is abysmal).

As a result, pension funds are not putting as much into the VC firms-- in Q1, according to the database of Private Equity Analyst, 23 venture capital funds raised $2.4 billion in the first quarter, a 64% drop from the $6.7 billion raised by 57 funds a year ago.

This causes the VC firms to clam up as well-- i.e., if you're not going to be able to raise another fund, you might as well drag out the current one as long as possible, right?

We'll see how the difficulties VC firms are having in raising money are filtering down to entrepreneurs in the next posting....stay tuned.