What Happens When Valuations Stop Surging

Last month, I wrote, “At 16 years old, this maker of fitness-tracker bracelets is no closer to making a profit than it was a decade ago.”

The company I was referring to? Jawbone.

It’s close to raising another $300 million. It has already raised $519 million in 11 rounds. Yep, VC companies are going back to the well a 12th time.

Jawbone’s most recent valuation was over $5 billion.

So let me repeat what I said in March…

The company has yet to generate a profit.

Are valuations running ahead of logic and common sense?

Consider Oscar Health‘s Series A raise…

When I read about it a couple of days ago, I could hardly believe it. I texted my fellow founder, Adam, this message: “Pretty friggin’ big Series A.”

Oscar raised $145 million.

True, its technology is pretty cool and addresses a big pain point. Oscar makes it easier for consumers to connect with health insurance plans and healthcare providers.

Adam’s response: “CrunchBase says it’s their fourth Series A, but WOW.”

Wow indeed. Oscar has promise. But it’s years away from making a profit.

Then, yesterday, it was Adam who was texting me. Zenefits was doing a new round.

“Zenefits reportedly raising at more than $3 billion: I remember when they raised on Wefunder at less than $10 million!” he wrote.

In less than two years, Zenefits’ valuation will have grown over 330 times.

Zenefits manages companies’ HR tasks – payroll, benefits, compliance and more – online. Adam and I have been following Zenefits ever since it caught our eye on startup portal Wefunder in mid-2013.

We’ve been singing Zenefits’ praises ever since.

But this valuation – which could go as high as $4 billion – took us both by surprise.

Valuations are getting richer and richer, and it’s not just the later rounds, as I explained in my last article, “Playing the Valuation Game: Is Earlier Better?

Higher valuations have seeped into the earlier rounds too.

Sure seems we’re in a bull. Not that there’s anything wrong with that, to paraphrase a certain comedian.

In my article, I said it’s true “the market will turn. And some companies that got bid up too high will be exposed.”

Such is the nature of boom and bust.

So far, “valuation trends are clearly benefitting early investors, regardless of whether they participated in a seed, Series A or Series B round. But they’ve benefited seed-stage investors the most,” I said last month.

I also warned that surging valuations may be hitting a wall in the next few years.

Now, I want to explain why.

Strong Macros

What could slow down rising valuations?

Well, the economy could go south. But I hate even raising this possibility. It’s too glib. The economy could always go south. And there are voices that never go away insisting that it will go south.

But there are other macros to consider. Maybe the 20 billion to 50 billion connected devices predicted by 2020 will turn into fewer than 10 billion.

Maybe governments will dust off their 20th century rules to stop marketplace companies from disrupting hidebound industries.

Maybe all the breakthroughs I’m seeing in mobile apps, robotics, healthcare and artificial intelligence won’t work out.

Maybe…

But who am I kidding?

The macros have never looked better.

There are seven macro-trends driving valuations up. I described them last summer (read the entire article here). The summarized list:

  • The rise of the global middle class
  • The rapid spread of the Internet
  • The deglorification of traditional, high-prestige professions
  • The dramatic improvement of multiple Web/mobile technologies
  • Low interest rates
  • The proliferation of smart devices
  • The easing of governmental restrictions on privately held capital and deal information.

The only macro in danger of disappearing? Easy money.

That’s not enough in and of itself to prevent valuations from climbing to new heights.

But the numbers NOT adding up is.

Numbers Don’t Add Up

Many startups IPO pre-profit.

For every Alibaba (expected to make over $9 billion this year), there seems to be 20 Boxes, which IPO’d this January having yet to make a profit.

Box is the rule, not the exception. Of the 37 companies that went public in the first quarter of the year, just 10 were profitable.

But making a profit is not the requisite test for a startup thinking of launching an IPO.

It’s revenues. For many reasons. The main one…

Going after profits prematurely could lead to companies cutting back on the spending needed to fund growth and scaling.

So forget profits.

But even the revenue numbers may soon have difficulty adding up. Consider…

When most companies debut on the public exchange, they trade at about 10 times revenue prices. That’s the industry average today for fast-growth software companies.

The problem? Pre-IPO valuations are ranging as high as 15 to 18 times projected revenue these days, according to this Bloomberg article (quoting three venture capital insiders).

For the not-so-hot companies, it’s lower. But for the really hot pre-IPO companies, the valuation can be much higher. In 2013, for example, TPG made a 27 times net sales (for the previous 12 months) investment in Uber.

At 10 times revenue, these new publicly traded companies would have to double (or nearly double) revenues for their post-IPO price to keep rising.

That’s a lot to ask.

Companies that have IPO’d recently had sales growth of about 25% year over year. In 2013, which had a stronger crop of IPOs than this year so far, sales growth was 50%.

So that 100% revenue growth is pretty much out of reach.

Box is managing a lame 14% annual growth rate in revenue. Is it any wonder its shares are down by 26% since it debuted on the New York Stock Exchange?

IPOs aren’t exactly killing it in the public markets. Fortune published a piece about this last week, called “Why this year’s IPOs have been awful.”

If this keeps up, it could lead to lower demand for IPOs among investors.

Is that a bad thing?

And how would it affect you as an early investor?

Here is my two cents.

What Happens Next?

So what happens if IPO demand goes down?

Pre-IPO companies would be less willing to do an IPO, since lower demand would force IPO valuations down.

If investors participating in a pre-IPO round can’t expect the IPO round to provide an even higher valuation, they’ll stop bidding valuations up so high.

To avoid this “valuation risk,” investors would also migrate down to earlier rounds in search of more reasonable prices.

But I don’t think it would be a massive migration.

As Paul Graham has noted, investors get used to the risk profile of the rounds they typically invest in. The risk profile of the early rounds should put off many later-round investors.

It’s very possible, however, that rising demand in the lower rounds would force valuations in those rounds up.

As a seed stage or stage A investor, though, you needn’t worry about valuation risk. In these early rounds, it’s lower than in the later rounds. (Remember, valuation is just one of many risks on the table.)

Your big winners will still be big winners (just not quite as big), even with scaled-back IPO valuations, something later-stage investors simply can’t claim.

The valuation risk is greater for them, in the sense that they’re more vulnerable to IPO “down rounds.”

But I see nothing on the horizon that would trigger a sudden and wholesale valuation reversal.

Five years ago, valuations in a pre-IPO round were 10 to 12 times revenue at the upper end.

Going back to that norm may not be in the cards. But 12 to 15 times revenue?

That would be fine by me.

I’d welcome founders and investors taking it down a notch in the pre-IPO rounds as opposed to going for the biggest valuation possible.

It would restore balance to the early investing market and reduce overall valuation risk.

And bring back a much-needed measure of common sense, to boot.

Good investing,

Andy Gordon
Founder, Early Investing