Startup valuation drop is a welcomed change

Venture capital experts believe the recent wave of lower valuations for certain unicorn startups is nothing to worry about; rather, they think it will push investors to be more selective and realistic.

Some venture capital-backed companies, such as Jawbone, Foursquare and Blue Bottle, have seen their valuations decline in recent weeks, but venture capital experts think it’s nothing to worry about.

The VC world has been sparking plenty of chatter in the past few years about “unicorns,” the venture-backed startups that receive a whopping $1 billion or higher price tag, and whether they are creating a VC bubble. Now that some startups are having down rounds, some are feeling the pain.

Investors who have committed capital to companies with dwindling valuations may worry about their investments and ultimately returns, and employees’ moral and stock options at these startups are likely to be impacted.

Recommendations app Foursquare raised $45 million for its latest round of fundraising, while the company itself was valued at $250 million. This is less than half of its value during its previous, Series D, fundraising, which raised $15 million, according to reports.

Silcon Valley-based VC firm Andreessen Horowitz led Foursquare’s Series B and C fundraising, DFJ Growth Series D, and Union Square Ventures Series E. Andreessen Horowitz declined to comment, while DFJ and Union Square Ventures did not respond to requests for comment.

Some venture capital professionals, however, don’t see these lower valuations as cause for concern.

“We have a fundamentally long-term, positive view on venture,” Adveq executive director Steven Yang told Private Equity International. “Regardless of if we call it unicorn today and donkey tomorrow, what will remain persistent is the creation of disruptive businesses.”

His reasoning comes from data Adveq analysed going back to the late-1970s that suggest that, at least since 2005, if 1,000 startups launch every year, about 2 percent of them become outliers worth more than a billion dollars. The 200 outliers may seem like a big number on an absolute basis, he said, but that only represents about 2 percent of new companies created in the last decade in the US.

“That distribution doesn’t change over time,” he said, adding that their billion-plus valuations are justified because they are growing at 100 percent, jumping their revenue growth in a short time frame.

He said the recent lower valuations are not out of the ordinary, as he has seen companies fall in value and then recapitalise to become market leaders in the end.

“It’s not going to be a pretty exercise; certainly you’ll see down valuations,” he said. “Investors in this segment are well-cognisant of the risk.”

Part of it could also be that these companies are waiting too long for their initial public offering (IPO), losing their momentum on the sidelines.

According to data from the National Venture Capital Association, 2015 saw drops in both the number of IPOs and the average IPO offer amount. In2015 the numbers fell by 34 percent to 77 IPOs and by 8 percent to $121.8 million from 2014.

“In a typical market cycle, companies go out [to IPO] in about seven or eight years,” Manhattan Venture Partners partner and head of research Santosh Rao told PEI. “Now it’s getting longer, around 10 to 12 years, so there’s a disconnect at some point. Most of the value is gone because the right time to go public is when you have traction. You have to go in there as opposed to stay in longer, as it happened with Dropbox.”

In terms of sectors, Yang said the consumer-facing businesses have been prominent in creating unicorns. It’s concurrently the sector that will likely experience volatility in valuations because it raised a lot of money and investor expectations are running high, he said.

Rao sees a big pushback for companies in the e-commerce sales business, citing online flash-sale platform Gilt Groupe and online furniture marketplace One Kings Lane.

“They themselves became flash sales,” he said. “That part of the industry has definitely gotten impacted.” 

Gilt was backed by Matrix Partners, SoftBank Capital, and General Atlantic and subsequently acquired by Hudson’s Bay Company on 7 January. One Kings Lane is backed by lead investors Kleiner Perkins Caufield & Byers, Greylock Partners, Tiger Global Management, IVP and Mousse Partners.

Yang and Rao seem to welcome this change.

“I’m hoping this market volatility could be a catalyst of putting a very firm reset on some of the investors’ expectations,” Yang said. “I would not expect the same accelerated fundraising as we’ve seen before. Predominantly, the tone is: don’t burn your money too quick.”

Rao said this pullback in the market forces private investors to be more selective.

“This correction, I’d say, is good for the private market; this is not the first or last time markets pull back, it’s not the end of the world,” Rao said. “There’s a lot of innovation going on and allocating capital won’t slow down. This is just when smart money comes in.”

Rao added that the impending compression of prices in VC will attract investors down the road, which is a good thing because a lot of people left the market when they thought valuations were out of control.

“Fundraising will not be as easy and you won’t see many up rounds,” Yang said. “With the exception of a few of course; it always comes down to the outliers. That’s what drives this business.”