Hitting The Wall

According to conventional wisdom, the meltdown of NASDAQ stocks in the first half of 2001 is a classic demonstration of the problems associated with the herd mentality and momentum investing in public securities. The crash dive in public values in turn caused a significant down turn in the valuation in the shares of those private firms with (or opting for) venture capital support. That being the case, commentators drew an obvious parallel… public and private equities hit the skids together; momentum investing on the way up was succeeded inexorably by a violent, momentum-driven down draft in valuations in both sectors, and allegedly for the same reason… faulty business models.

Of course, in a significant sense, price levels of high tech firms in the public markets have a significant influence on the valuations of firms still private. An IPO entry into the public markets is one of the ultimate payoffs for a venture-backed firm; no surprise that the valuations achieved in private rounds mimics the public high-tech stock curve. But, there was another phenomenon at work in the recent crash dive which has not been so widely noticed. A number of private firms were innocent victims of the public stock meltdown. They have either failed or been brought to a standstill in their progress by the psychological effects of the meltdown more than anything else… a psychological effect which cannot, under any rational scenario, be described as their fault.

A hypothetical illustration should be useful: An early stage firm ('Newco') obtained angel financing in 1999 and closed a Series A Round in the first quarter of 2000. The post money valuation following the angel round was $5 million; following the Series A Round (Newco raised $5 million from venture capitalists) it was pre-money $10 million and post money, $15 million. At the time of the Series A Round, it was anticipated that the company, if it worked its plan, would need another $7 to $8 million to get to cash flow break even. And, the existing VCs, plus colleague firms they expected to invite into a syndicate, encouraged management to believe they would be there for the Series B Round. Let’s further assume that the company worked its plan more or less on schedule, burnt through the Series A proceeds (again as expected) and now approaches its professional investors for the anticipated Series B Round. The common shareholders (the angels, the founders and the management) are, of course, ready for a significant disappointment in terms of valuation. They steel themselves against the probability the investors will demand a pre-money valuation which reverts (perhaps) to the angel round number, $5 million, meaning significant dilution for the common shareholders. The problem for any number companies, however, has been that the Series B Round cannot be financed at all. The VCs are traumatized; they are simply not willing to write checks, except perhaps to keep the company running on some form of controlled maintenance basis, making sure it stays alive in the portfolio but without any commitment allowing for future growth… the growth which the other shareholders had, legitimately they thought, anticipated.

To make the hypothetical worse, let’s assume that there was no VC money in the company as of March 2000 but the angels, the friends and family and others had reason to anticipate, based on oral conversations, that a Series A Round was in the cards, a round which would get the company where it would want to go, according to plan. If there are no professional investors in the stock, the odds are that even cash for maintenance and hibernation is unavailable; liquidation is required. The fact that the company has performed according to plan, is well managed, has a sound model, cool technology, etc., is irrelevant. The excessive optimism during the so-called ‘bubble’ has been replaced by excessive and unreasoning pessimism. Traumatized investors are simply sitting on their wallets, even though bargains are abundant. As I have been remarking since I first started writing in this business, the current level of public stock prices should not be the sole determinant vis-à-vis the valuation of private, (particularly early stage) investments; the early stage owners are not going to be looking for a liquidity event for another, say, three to four years… when public stock prices will be at a level that no one can forecast today. As Hetty Green, the late 19th century investor/miser, was accustomed to saying, “Next to my children, I love a good panic more than anything else.”

But sadly, too few investors are listening to the sound advice and picking up the bargains, therefore there are any number of companies in the category we have described in the hypothetical, some out of business and some marking time, with a hope that investors will come to their senses in the first quarter of 2002. If that does not happen, this country will have wasted an enormous amount of productive energy and capital, capital which, in many instances, was intelligently deployed when the investment was made. The business models were sound, the management was good, the market was there; everything was aligned in good order, except investment psychology.