As stock markets have tumbled, public company shareholders were not the only ones wondering what would become of their portfolios. Venture capitalists also began fretting about whether the plunge - which resulted last week in the worst week for American stocks since 2011 and a renewed sell-off on Monday - would cool the heady market for shares of private companies, especially in Silicon Valley.
There is reason to worry: The number of start-ups valued at $1 billion or more has jumped to at least 131, up from less than a dozen in 2010, according to the research firm CB Insights. The total amount of venture money invested has also more than doubled, to $50 billion in 2014, from $23 billion in 2010, with venture funding in the second quarter exceeding $17 billion for the first time since the end of 2000, according to the National Venture Capital Association. All of that froth has some wondering if it's time for Silicon Valley's heat to cool off.
Yet those anticipating a collapse in start-up land will probably have to wait. Any adverse effect on venture-backed companies is likely to be uneven and more complicated than a straight bust. Instead, the effect of a stock market rout is set to move slowly across the start-up landscape, creating a gulf between well-run companies with achievable business plans and those that were funded as part of the back-everything frenzy that began earlier in the decade. But once negative sentiment takes hold, a more widespread downward spiral could quickly unfold.
The reason that there will most likely be no uniform start-up deflation is rooted in the pricing of private company stocks. The prices for start-up shares, which are closely held by small groups of investors, generally reset only when the founders go into the market to raise money. (In contrast, public stock prices rise and fall every day in response to a company's performance and market sentiment.)
Over the last few years, start-up share prices have gone up nearly every time a private company has raised money. Investors were largely optimistic and generous because they assumed that a variety of factors - including low interest rates, a strengthening American economy and the growing Chinese middle class - would keep the markets positive. Spending more to help a start-up grow into a huge company seemed like a reasonable bet.
It is only when companies absolutely need to collect new financing that the rubber may hit the road - that's when investors may want more reassurances that the start-ups can survive without the crutch of venture money to subsidize growth. If a start-up cannot provide those reassurances, or if a company has burned through all of its money from previous funding rounds without reaching agreed-upon goals, that could spell trouble.
So in the immediate future, a downturn that spreads to Silicon Valley start-ups "will affect those companies that need to raise capital," said Matthew Rubin, the director of investment strategy at the asset management firm Neuberger Berman. He said it could take several months for a market collapse to affect the valuations of high-flying private tech names.
Bill Gurley, a prominent venture capitalist, raised the issue of changing fortunes for start-ups last week when he voiced his fears of about a slowdown on Twitter. "Investors are likely to refocus on business model viability and path to profitability," he wrote. "This will seem like an abrupt sea change to many." He wondered how many entrepreneurs would be prepared for such a shift.
Start-ups that cannot adapt to a world that prizes profit over growth may ultimately be forced to raise money at the same or lower valuation than in the past, something referred to as a "down round." Those can be debilitating: Employee stock options usually become less valuable when a company's valuation falls, making it harder to retain people. If a company has raised many rounds of capital, later investors often have protections that guarantee a specific cash payout or return on investment. In a down round, those protections are paid for out of the returns that would have gone to earlier investors and employees.
As those companies flounder, however, others that have been prudent stewards of capital and can show a path toward profit will still attract capital, especially as billions of dollars held by venture and sovereign wealth funds have not yet been invested.
Since 2014, venture firms including Norwest Venture Partners, Founders Fund, Andreessen Horowitz and Institutional Venture Partners have each raised at least $1 billion for new funds. Temasek, Singapore's state investment company, and other sovereign funds have also begun putting more money into private tech companies.
Venky Ganesan, a managing director at Menlo Ventures, said the phenomenon of high-valuation tech start-ups and a market awash in easy money encouraged companies to spend at breakneck speeds.
"There is already a chill in the late-stage funding market," he said. That's partly because start-ups have become dependent on mutual funds and other public market investors for cash. Every quarter they can mark down the value of their private holdings, which could cast doubt on the valuations of start-ups in the same lines of business. "If you see down rounds and mutual funds report losses on private companies, then things will spiral downward very fast," Ganesan said.
"Like in Game of Thrones, winter is coming."
Kevin Mak, the director of Stanford's Real-Time Analysis and Investment Lab, said financing was still readily available for young companies. He is also an adviser to a three-year-old commerce start-up called Massdrop that closed a $40 million investment two weeks ago.
"We started the fund-raising process two and a half months ago when the market was falling and it didn't have a major effect," Mak said. "When and if we see the market fall 20 per cent or more, it will filter through more. But it will primarily be the frothiness of the market coming down."
It is probably not a bad thing if some private companies stumble, since the start-up market lately has been like Lake Wobegon, a place where all businesses have been above average. Any venture capitalist will also say that the majority of start-up investments lose money and the few bets that pay off offset the losses. So it may be better to identify ailing companies, especially among the enormous $1 billion valuation club, earlier rather than later.
"Lots of founders today weren't around in 1999 and they don't know a thing about financial markets beyond what's happened in the last 24 months," Gurley said in an interview. "To them that's how this game is played, money is cheap and everything goes up. That's why we have cycles."
There is reason to worry: The number of start-ups valued at $1 billion or more has jumped to at least 131, up from less than a dozen in 2010, according to the research firm CB Insights. The total amount of venture money invested has also more than doubled, to $50 billion in 2014, from $23 billion in 2010, with venture funding in the second quarter exceeding $17 billion for the first time since the end of 2000, according to the National Venture Capital Association. All of that froth has some wondering if it's time for Silicon Valley's heat to cool off.
Yet those anticipating a collapse in start-up land will probably have to wait. Any adverse effect on venture-backed companies is likely to be uneven and more complicated than a straight bust. Instead, the effect of a stock market rout is set to move slowly across the start-up landscape, creating a gulf between well-run companies with achievable business plans and those that were funded as part of the back-everything frenzy that began earlier in the decade. But once negative sentiment takes hold, a more widespread downward spiral could quickly unfold.
The reason that there will most likely be no uniform start-up deflation is rooted in the pricing of private company stocks. The prices for start-up shares, which are closely held by small groups of investors, generally reset only when the founders go into the market to raise money. (In contrast, public stock prices rise and fall every day in response to a company's performance and market sentiment.)
Over the last few years, start-up share prices have gone up nearly every time a private company has raised money. Investors were largely optimistic and generous because they assumed that a variety of factors - including low interest rates, a strengthening American economy and the growing Chinese middle class - would keep the markets positive. Spending more to help a start-up grow into a huge company seemed like a reasonable bet.
It is only when companies absolutely need to collect new financing that the rubber may hit the road - that's when investors may want more reassurances that the start-ups can survive without the crutch of venture money to subsidize growth. If a start-up cannot provide those reassurances, or if a company has burned through all of its money from previous funding rounds without reaching agreed-upon goals, that could spell trouble.
So in the immediate future, a downturn that spreads to Silicon Valley start-ups "will affect those companies that need to raise capital," said Matthew Rubin, the director of investment strategy at the asset management firm Neuberger Berman. He said it could take several months for a market collapse to affect the valuations of high-flying private tech names.
Bill Gurley, a prominent venture capitalist, raised the issue of changing fortunes for start-ups last week when he voiced his fears of about a slowdown on Twitter. "Investors are likely to refocus on business model viability and path to profitability," he wrote. "This will seem like an abrupt sea change to many." He wondered how many entrepreneurs would be prepared for such a shift.
Start-ups that cannot adapt to a world that prizes profit over growth may ultimately be forced to raise money at the same or lower valuation than in the past, something referred to as a "down round." Those can be debilitating: Employee stock options usually become less valuable when a company's valuation falls, making it harder to retain people. If a company has raised many rounds of capital, later investors often have protections that guarantee a specific cash payout or return on investment. In a down round, those protections are paid for out of the returns that would have gone to earlier investors and employees.
As those companies flounder, however, others that have been prudent stewards of capital and can show a path toward profit will still attract capital, especially as billions of dollars held by venture and sovereign wealth funds have not yet been invested.
Since 2014, venture firms including Norwest Venture Partners, Founders Fund, Andreessen Horowitz and Institutional Venture Partners have each raised at least $1 billion for new funds. Temasek, Singapore's state investment company, and other sovereign funds have also begun putting more money into private tech companies.
Venky Ganesan, a managing director at Menlo Ventures, said the phenomenon of high-valuation tech start-ups and a market awash in easy money encouraged companies to spend at breakneck speeds.
"There is already a chill in the late-stage funding market," he said. That's partly because start-ups have become dependent on mutual funds and other public market investors for cash. Every quarter they can mark down the value of their private holdings, which could cast doubt on the valuations of start-ups in the same lines of business. "If you see down rounds and mutual funds report losses on private companies, then things will spiral downward very fast," Ganesan said.
"Like in Game of Thrones, winter is coming."
Kevin Mak, the director of Stanford's Real-Time Analysis and Investment Lab, said financing was still readily available for young companies. He is also an adviser to a three-year-old commerce start-up called Massdrop that closed a $40 million investment two weeks ago.
"We started the fund-raising process two and a half months ago when the market was falling and it didn't have a major effect," Mak said. "When and if we see the market fall 20 per cent or more, it will filter through more. But it will primarily be the frothiness of the market coming down."
It is probably not a bad thing if some private companies stumble, since the start-up market lately has been like Lake Wobegon, a place where all businesses have been above average. Any venture capitalist will also say that the majority of start-up investments lose money and the few bets that pay off offset the losses. So it may be better to identify ailing companies, especially among the enormous $1 billion valuation club, earlier rather than later.
"Lots of founders today weren't around in 1999 and they don't know a thing about financial markets beyond what's happened in the last 24 months," Gurley said in an interview. "To them that's how this game is played, money is cheap and everything goes up. That's why we have cycles."
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