A Lesson in Gravity

We have been speaking with a steady stream of companies raising money lately and the (admittedly anecdotal) outlook is not great. Put simply, if you have money you can get more, effectively as much as you want. If you do not, times are hard.

Governments of the world, especially the US, have flooded the markets with cash (insert icon of money printer going brrrr). Unfortunately, the way that money hits the system is largely through the stock and bond markets which has the affect of inflating asset prices. Trading multiples for public entities are essentially at record highs, and while this is most concentrated on the top 20 or so technology names, the inflation exists in many other parts of the market. We recently spoke with a banker helping his industrial client to acquire some smaller, adjacent companies and he was shocked to see all the targets were trading at 15x-20x EBITDA despite boasting anemic growth. Another banker we know went to pitch a company on an IPO and was relieved when that company was wiling to accept a valuation of 15x revenue.

We have also seen recent data showing that seed funding fell in the 3rd quarter. Not by a huge amount, but still the wrong direction.

What this means in practice is that it is going to be very hard for new companies to get started, and even harder for seed stage companies to transition to Series A investments from more traditional, well-known VCs.

We have no more ability to predict the state of the economy than anyone else in 2020. But it is hard to be too optimistic. For the narrower, tech industry, especially the start-up landscape, the outlook is decidedly mixed. Raising money is hard, but fortunately costs are down. Rent in the Bay Area has obviously fallen considerably, and employee costs are a bit more flexible as people work from lower-costs areas. On the other hand, customers are slower to make purchase decisions, outside of a few critical, high priority areas (WFH, Covid mitigation, etc.).

While unspoken, our sense is that the larger VC funds are sitting on their hands a bit. When is Sequoia going to publish their latest Tombstone pitch deck, Halloween is approaching. None of the large funds want to be overly vocal about conditions because the IPO Window is wide open. It is hard to tell your LPs that hard times are coming when the other side of the shop is pitching the IPO of the jewel of the portfolio at a 1999-era multiple. Behind the scenes however, we know several funds that are passing on deals they would made nine months ago. This is doubly strange because the big institutions have a fair amount of dry powder. The one missing piece of this puzzle is the LPs – the investors in the VC investors’ funds. When was the last time we saw a headline about a Tier 1 firm raising a multi-billion dollar fund?

At some point, gravity will re-assert itself on the stock market. Could be next week, could be right after the election, could be next year. Who knows. But at some point that IPO window will shut. That will likely come at a time of wider liquidity shortages in the market, meaning LPs will be less likely to invest heavily in VCs. This will be a pretty bleak time.

Maybe it will not come to pass. Like we said, our predicative abilities are completely dampened. That being said, we do think it likely that at some point in the not too distant future, the VC spigot will shut down. If you have an income, if your company has cash in the bank, this will not be a disaster. It may even help. There is an awful lot of excess in the system, and a cooldown will allow good companies to operate with far less distraction. But it will be important to have the resources to last through that winter.

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