Some thoughts on when to raise money, and the current financing environment

A key question for founders is when they should try to raise money. More specifically, they often wonder whether to raise money now or wait, say, 6 months when their startup has made more progress. Here are some thoughts on this question generally along with some thoughts on today’s venture financing market.

- In the private markets, macro tends to dominate micro. Venture valuations have swung by roughly a factor of 4 over the last decade. In finance speak, venture tends to be high beta, moving as a multiple of the public markets, which themselves tend to move more dramatically than economic fundamentals. Hence, it is easy to imagine scenarios where the same private company will command 1/2 the valuation in 6 months due to macro events, but it’s rare for a company to increase their valuation 2x through operations alone in 6 months.

- Therefore, when it seems to be the top of a venture cycle, it’s almost always better to raise money sooner rather than later, unless you have a plausible story about how waiting will dramatically improve your company’s fundamentals.

- Prior to the Facebook IPO, the consensus seemed to be that private valuations were near the top of the cycle. Today, FB is valued at up to 50% below what private investors expected. Moreover, the financial crisis in Europe seems to have worsened, and unemployment numbers in the US suggest the possibility of a double dip recession.

- It takes many months to understand how macroeconomic and public market shifts affect private company valuations since (with the exception of secondary markets) private transactions happen slowly. So we don’t know yet what these recent events mean for private markets. According to a basic rule of finance, however, it is safe to assume that companies “comparable” to Facebook are worth up to 50% less than private investors thought they were worth a few weeks ago.

- The question then is what companies are comparable to Facebook. Clearly, other social media companies with business models that rely on display or feed based advertising are comparables. Internet companies that have other business models (freemium, marketplaces, commerce, hardware, enterprise software, direct response advertising, etc) are probably not comparables. The public markets seems to agree with this. Defensible companies with non-display-ad business models have maintained healthy public market valuations.

- One counterargument to the “all social media companies are now worth less” argument is the discrepency between how the smart Wall Street money and smart internet money views Facebook and social media companies generally. The smart Wall Street money thinks like Mary Meeker’s charts. They draw lines through dots and extrapoloate. This method would have worked very poorly in the past for trying to value tech companies at key inflection points (and tech investors know that what matters are exactly those inflection points). In Facebook’s case, Wall Street types look at revenue and margin growth and the trend toward mobile where monetization is considerably worse (for now). Smart internet investors, by contrast, look at Facebook in terms of its power and capabilities. They see a company that is rivaled only by Google and Apple in terms of their control of where users go and what they do on the internet. Smart internet investors are far more bullish than smart Wall Street investors on Facebook. Thus if you believe the internet perspective over the Wall Street perspective, you’d likely believe that Facebook and social media in general is undervalued by the public markets.

http://kidmercury.posterous.com/ kidmercury

macroeconomics is painfully simple, the hardest part is psychologically accepting the implications and acting accordingly. there are no savings and there is an excessive debt burden; as future earnings are dependent upon current savings and future access to credit, the forecast for earnings for most businesses looks particularly ominous. the fed will keep printing money to obfuscate this; doing so will only create bubbles and income inequality resulting from inflation of the money supply (i.e. fb top dogs get to be billionaires, we pay for it with $4+ gas). interest rates are going to need to start going up at some point, perhaps within a few years, at which point you can kiss american-style finance of Q round fundings for unprofitable companies good bye.

the sooner it is accepted that there is no going back to normal and a massive political and economic restructuring is required, the sooner we can get on with prosperity for everyone and all that good stuff. the longer the need for non-violent revolution is ignored, the more painful the economic consequences will be. this is not so much a bold forecast as it is an observation of the laws of supply and demand pertaining to where earnings come from (savings and future credit).

for entrepreneurs: get used to bootstrapping, even more than before. for investors, bubble 2.0 is popping. buy when it’s fully deflated or, better yet, move on to the next bubble(s).

http://www.cdixon.org/ chris dixon

I know you have strong views on this, but my view is macroeconomics is a lot more nuanced than that.

http://kidmercury.posterous.com/ kidmercury

yes i know i am a broken record, and a religious fanatic, which can make for a remarkably annoying combination — thank you for your tolerance. in due time the consequences of a world in which all money is loaned into existence will be understood by all, as they have before throughout history. the only difference is this time we have the internet, so how the problem gets solved has the potential to be quite different. but anyway, few are likely to be persuaded now; rather when bubble 2.0 has fully collapsed and new bubbles are appearing the inescapable nature of the laws of supply and demand will be more apparent.

http://bernardi.me/ Stefano Bernardi

While I agree 100% on the macro view, I’m failing to understand why you are tying that to the tech world (“bubble 2.0 is popping”).

Given your macro view, I could see way more bubbles popping before the tech one.

I also think that startups that are creating value, should not get obsessed by macro-views as much. Keep your coffins well full and then focus on creating more. Your outputs and assets will probably not be translated in USDs, but they will still hold intrinsic value and could be exchanged or leveraged with other currencies.

http://kidmercury.posterous.com/ kidmercury

i agree there are other bubbles that could be popped, that is a matter of timing and order flow (analysis of speculation). the connection to the macro view is that every business needs earnings to be a real business, and earnings are dependent upon current savings and access to credit in the future. there are no current savings and debt levels are already maxed out. if there is to be earnings in the future, savings need to be re-built. this can only happen if prices fall and, more importantly, if debt — particularly national debt — is cancelled and reduced.

startups can create all the value they want, if there are no customers with money to buy their stuff, they will have trouble surviving. there are a number of poor countries in africa that are permanently in debt and have no savings. it may be worth noting that they do not have vibrant economies or startup scenes. it doesn’t matter what entrepreneur you put there, if there are no customers, the business will fail. (to its credit some countries in africa are finally turning around, thanks in part to debt cancellation)

http://twitter.com/lchamberlin Luke Chamberlin

Connect the dots between FB IPO and $4 gas.

http://kidmercury.posterous.com/ kidmercury

gladly! first, i’ll share an infographic i created that may help tell part of the story visually:

http://visually.visually.netdna-cdn.com/HowGoldmanSachsStoleSiliconValley_4f710ea391a17.jpg

(yes i know my design skills leave much to be desired! )

okay so here’s the basic story:

1. government needs to expand the money supply for the 2008 bailouts. government is always expanding hte money supply, which is why prices of everything are always rising, but where that expansion of hte money supply goes can vary. in 2008, goldman pocketed billions from expansion of the money supply.

2. goldman then decides to do some investing. facebook, groupon, etc — bubble 2.0. bubbles are always associated with expansion of the money supply; there is a book available for free online called early speculative bubbles and expansion of the money supply by doug french that is a good read on this subject (although the title basically tells you the story).

3. expansion of the money supply pushes prices up for everything. where that money gets spent first is where prices will rise the most. however, prices are going to rise as all that money trickles down. academics refer to this as the cantillon effect.

4. the end result is that there is a wealth transfer from those who hold dollars to those who hold facebook shares. we have had such outrageous expansion of the money supply over the past 40 years that we now have a world that is completely without savings. that is why we are at the end of the inflation scam; there is no more savings left to steal. as there are no more savings, and as credit is maxed out, there are no more future earnings until we get a “grand reset,” preferably in the form of debt cancellation and in revision of how money is created and distributed so that the inflation scam is not so easily and perpetually manifested.

http://twitter.com/lchamberlin Luke Chamberlin

I knew you wouldn’t let me down!

Anonymous

Out of interest— isn’t this predicated on the assertion that raising money at inflated rates is better? Should one not prefer to raise money at a reasonable valuation for the benefit of the market as a whole?

http://www.cdixon.org/ chris dixon

You can always take a lower valuation. The market sets the ceiling.

http://www.iphoneil.net/?author=2583 Ronen Mendezitsky

I don’t think you can compare valuation assessments between public and private companies, especially when the private companies are ventures in nature. I don’t think VCs or any other Startup investors value companies at a logical valuation. Facebook is a great example of an over valued company. I’m not saying that Facebook won’t be worth a 100$B some day, even more, but it certainly isn’t worth that judging by the micro of the company. As for macro, yes, it affects all markets, but I don’t think it affects ventures’ high evaluation – The war for getting there first still exists even if VCs fear the option of not being able to raise as much capital for investments as before due to global economic turmoil.

Now, for my original reply which is totally unrelated… Why isn’t there a stream of related articles about “When to fund” showing on either side of my screen while I’m reading this, so I can benefit from other articles of the same nature?

http://www.cdixon.org/ chris dixon

You can always take a lower valuation. The market sets the ceiling.
http://www.cdixon.org/ chris dixon

I disagree. VCs look at public markets as a guide and eventual source of liquidity.

http://www.iphoneil.net/?author=2583 Ronen Mendezitsky

True, but this does not make the crazy valuations given to these companies any closer to reality.

http://jasoncrawford.org/ jasoncrawford

Re: “Wall Street types look at revenue and margin growth and the trend toward mobile where monetization is considerably worse (for now). Smart internet investors, by contrast, look at Facebook in terms of its power and capabilities.”

Agree, this is the difference in perspective between the Facebook bulls and bears. I wrote this recently: “The bears are only looking at Facebook’s current revenue model. The bulls are thinking about all the potential revenue models Facebook could launch, given their (highly defensible) assets.” http://jasoncrawford.org/2012/05/the-difference-between-facebook-bulls-and-bears/
http://blog.19lights.com John Hable

In other words, that takeaway that I’m seeing here is “if you can raise money now, do it unless you have a really, really, really good reason not to”. Personally, I think most people in the US severely underestimate the risk in Europe. 2008 taught us that a sharp shock to the economy basically ruins venture financing (because VC firms know that their LPs can’t pay capital calls).

So then will a Lehman-like vent happen in the next 6 months? No one knows for sure. But there is a lot of debt that no one knows how to pay. Does anyone really expect Greece to pay the Troika back at par? And what sane person would buy Spanish bonds at 6% when Europe has made it ok to retroactively change bond terms and effectively subordinated all private holders? At some points these debts either have to paid back or written down, and if they are written down it could very well cause a default cascade. Or everything will be fine.

So in other words if you have the option, I’d take it.

http://www.cdixon.org/ chris dixon

I’d tend to agree.

http://twitter.com/jwmares Justin Mares

Great post. What are your thoughts on starting to raise money now, in an early stage, vs. waiting 6 months when company fundamentals have the chance to be completely different? Any timelines on when this venture cycle starts trending downward?
http://bernardi.me/ Stefano Bernardi

I think there is a part you left out, and that is keeping one eye on firms raising new funds.

Recently a lot of top-quartile funds have raised some pretty huge funds that they will have to invest anyways, granted that valuations and hot markets might swing by quite a bit, but that’s why the macro element is important, cause investors might sometimes also be right in thinking that a market is saturated (earlier than MBAs )

Basically my opinion is: if you’re building something that adds real value, in a market where you can achieve a dominant position, it’s always the right time to raise money.

http://www.cdixon.org/ chris dixon

I would argue that even if you are building the right product at the right time, market timing matters.

http://bernardi.me/ Stefano Bernardi

I see your point but I still don’t totally agree, based on my previous point of VCs raising new funds.

That cash is not impacted in any way by the public markets or macro-conditions for 10 years, and even if they might get cold feet on a market, they would not want to loose the hot stars of a new market.

The VC ecosystem plays a large role in this too, and the extreme early stage competition is what may also be driving valuations upward at later stages.

If you can settle on market timing + VC competition, we have a deal.

http://www.cdixon.org/ chris dixon

Want to talk specifics? I know all the funds and their current postures. Happy to debate it with you.

http://bernardi.me/ Stefano Bernardi

(Hope I didn’t sound aggressive)

I see your point about public markets being a guidance for valuations, and of course impacting the intrinsic value of a company for its IPO prospects.

I didn’t mean to say I have any inside knowledge or anything, what I’m saying is that First Round, A16Z, NEA, KPCB, Sequoia all raised new funds very recently.

Seed stage doesn’t look bad either with 500, Lowercase, etc. all raising new capital.

All this capital will be invested no matter what, as said probably with lower valuations and different markets, but the companies I was referring to in the previous comments don’t need to worry imho.

Of course, if you’re building the endless social company you will prob get a lower valuation or no cash at all, but that results from a mix of factors including: more competition, user time saturation, etc. with public markets being one of them.

http://blog.19lights.com John Hable

“All this capital will be invested no matter what…”

That’s not entirely true. Raising a fund doesn’t mean that you actually have money to spend. All it means is that your LPs are contractually obligated to give you that money if you ask for it.

Most LPs are large funds like endowments that have strict rules on asset allocations. Say, only 1.3% of their total fund is allowed to be VC. If the other 98.7% of the fund has a sharp drop in value, then the LPs need dump their VC stakes, which is hard because everyone needs to do it at the same time, and VC investments are very illiquid.

That’s why no one could raise money in 2008. While the LPs were contractually obligated to give money, VCs knew that their LPs didn’t actually have the money. VCs would much rather wait 3 years for things to blow over than ask for a cash call that their LPs can’t make.

So if there is a sharp market moving event then funding can suddenly dry up. These kinds of events are more common than most people believe. There was the 2000 dot com burst, 9/11 (in 2001), and Lehman in 2008. But Europe could very well could be the catalyst that causes all funding to dry up. I’m not saying it will or will not happen, just that there is a very real risk. Note: Greek elections in 2 weeks.

http://engag.io/ William Mougayar

I agree. Market timing is so important. It can kill or put wings on any product.

http://engag.io/ William Mougayar

Also, figuring out the metrics and revenue possibilities happens a lot faster these days. So, you can have these signals earlier in the startup cycles than before.
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Jan Pstrokonski

Great post!
The key thing in my mind is that you need to look at the valuation *relative to* its potential.
Jan
http://www.smartjapanesestocks.com
Anonymous

I agree THX for your post, reblog @ http://www.technologizm.pl
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http://twitter.com/lchamberlin Luke Chamberlin

What is the affect of the Facebook or similar tech IPOs in terms of creating new angel investors out of the early employee ranks? Does that create a temporary spike in venture capital?

http://www.cdixon.org/ chris dixon

It will definitely create new angel investors and will probably create a spike, especially in early stage (seed) investing.

http://twitter.com/isaacgarcia Isaac Garcia

So are you saying that Buddy Media is really worth $1.35b?

http://www.cdixon.org/ chris dixon

Well, Buddy Media has a strong enterprise sales business model. Not sure they are a comparable to Facebook.

http://twitter.com/isaacgarcia Isaac Garcia

a strong enterprise sales model based entirely on consumer/social advertising. I understand the difference, I do, but I also believe that the platforms (BM) and the data that feed them (social, facebook, etc.) are highly parasitical, and thus will ultimately track together.

http://www.cdixon.org/ chris dixon

I agree it is dependent on social advertising (and specifically FB), but would argue the sensitivity of a SaaS model to advertisers is far lower than it is to Facebook RPMs. Seems kind of no brainers you’d pay, say, 10K a month to manage FB ads vs that you’d spend millions to actually advertise on FB.

Anonymous

I disagree with the last sentence. The social media sector might grow larger than the market’s expectation right now , but that doesn’t mean facebook is going to get all the profit and pageviews from it for years. I think the wall street people are thinking too bubbly about facebook.
If you think about photo sharing sites, first there was flickr and then came instagram, and probably more other sites like pinterest. The photo sharing sector is growing , but that doesn’t mean there’s no chance other than flickr. Thinking that facebook is going to be the largest sns site for the next decade or so and also thinking that the social media sector is going to keep growing doesn’t fit well.
http://www.engineperformancechip.com/ sam carson

Why did facebook IPO plan failed? Is it going to rise again or not? I was thinking to buy some shares of it. Thanks god i was just thinking.
http://twitter.com/xpertfinancial Xpert Financial

I agree with these points. I also want to point out that the valuation expectations of early/seed stage companies has dramatically increased to the point that when a series B – C round comes around, the expectation of the entrepreneur is rarely the price at which the investors will buy in at. The influx of seed stage money has set up series B and C rounds for unrealistic expectations and inevitably an unhealthy scramble for capital down the line.
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Chris Dixon