Two common discussions in the startup world right now are 1) the increasing speed at which new apps/websites can gain mass adoption (Instagram, Pinterest, OMGPOP’s Draw Something, etc), and 2) the rise in seed stage valuations. These two trends are real and related. An investor with a broad portfolio of companies might rationally invest at an average valuation of, say, 10m (which is historically considered very high for that stage) if they have a chance for one of the investments to become the next Instagram or Pinterest. A billion dollar hit pays for a lot of misses.
The increasing velocity has implications for the valuations of incumbent tech companies. Users have limited time, and while web and app usage are growing, hit startups are growing much faster and therefore gaining adoption, at least in part, at the expense of incumbents. It’s not clear this risk is priced into the valuations of companies like Facebook (P/E expected to be ~100) and Zynga (P/E ~31). In other words, faster velocity should lead to a narrower distribution of valuations from seed to late stages. We’ve seen the seed stage adjust but not the late stage.
The current posture of big VCs seems to be to wait to see what takes off and then chase the winners. Tons of investors tried to invest in Instagram’s A and B rounds, and I’m sure VC interest in Pinterest is intense.
The problem with this model of Series A and B investing is that, in reality, many of the companies with big hits weren’t overnight successes. Pinterest, OMGPOP, Twitter, and Tumblr were around for years before taking off and all benefited greatly from having patient investors. In the current financing environment, a lot of good companies won’t live to get Series As and Bs and big VCs will pay valuations on hits that are priced to perfection.
Increasing velocity is great for users and for the winning companies and investors. But when good companies aren’t getting follow on rounds because they aren’t yet “hockeysticking”, the long term health of the startup ecosystem suffers.