Several private, venture-backed companies have achieved rapid and extreme valuation mark-ups. This has obviously been going on for some time now in Silicon Valley and the private tech sector, but the magnitude and frequency of the recent write-ups has given me pause. I’ve been trying to piece together the ingredients that are creating this environment, and it comes down to the following: Scarcity, momentum, FOMO and gains:
Despite the fact that public market stock performance has been muted so far this year, private market valuations continue to surge upwards. Why this dichotomy? One big factor is scarcity. Private companies don’t raise money every day. If a VC wants to invest in a company, she may only get the option once a year. Given all the big funds that have been raised, fierce competition naturally ensues for these scarce slots in the most attractive companies. As a result, the prevailing logic of the winning bidder tends to be along the lines of “this might look expensive today based on fundamentals (or lack of fundamentals), but this will look like a great price down the road when this company is worth much more as it grows.”
Contrast this with public market investors who don’t face the same scarcity problem. There is a price every day for the shares of the companies in their universe. For public market investors, there is no scarcity, only a need to pick wisely and in a timely manner. As a result, valuations tend to make more sense based on current and near term future expected financial performance. Sure, there are expensive public stocks but, even for newly IPO’d companies with limited public floats, high multiples are driven by fairly broad-based demand versus a high price based on the winner of a scarcity auction.
Another reason the magnitude and frequency of write ups hasn’t abated (and may be increasing) is that the strategy of overpaying in the scarcity auctions for the most attractive companies has generally paid off. As more capital has entered the high growth, venture-backed “asset class” (it’s really more of an asset niche), the dynamics have only intensified. So, each time an attractive company has opened its gates to new capital, the ensuing competition has driven valuations even higher for the winning bidder. Emboldened by these write-ups, existing players have stayed aggressive and more new capital has entered the system. The momentum has continued to build.
3. Logos and FOMO
A third powerful driver of the current write-ups is the thirst for the best “logos.” As branding has become more important for VC firms, the desire to be associated with winning companies has intensified. In the long run, VC funds should be judged by the returns they generate. But, in the shorter run, success can be claimed by having investments in hot companies.
The best companies are attracting bids from firms that probably know they’re overpaying. In many cases, these firms believe they may not make a huge return on these investments, but being associated with great companies can be just as important as making a good return in certain circumstances. The current market momentum has ensured that this strategy hasn’t led to many high profile write-downs as of yet; buying logos has worked well — so well, in fact, that more and more firms want to play, not risking missing out on big winners such as Alibaba (BABA) and Uber.
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What can we take from all of this?
In the short run, venture returns are looking very strong. How much of these returns, however, are paper gains versus true realizations? That’s a critical question.
Paper gains have come but they can also go. Some firms have begun to quietly sell down some of their big winners, before IPOs. I suspect we may see even more of this activity as hot private companies see rapid price appreciation and continue to defer IPOs where prices will inevitably be lower.
While we’re in this market, entrepreneurs running popular companies should stay aggressive where warranted. In nearly all segments of technology, market leadership bestows disproportionately large (and in many cases non-linear) valuations. So, investing aggressively to stay ahead of the competition makes good sense. But have a back-up plan to live off of current cash. If the market turns, you’ll be glad to not have to raise another round in a tougher valuation environment!
Glenn Solomon (@glennsolomon) is a Managing Partner with GGV Capital. Some of his recent investments include Zendesk, Nimble Storage, Pandora, Successfactors, Isilon, Domo, Square, AlienVault, HashiCorp and Quinstreet. This post originally appeared on his blog.