Meltdown bodes ill for late-stage valuations

Drop in public markets and lack of exits will begin pushing down more private-company rounds

With the Nasdaq dropping near two-year lows and the IPO drought continuing, we could soon see the average valuations of late-stage VC-backed startups start to drop. 

That's because private-company valuations that depend on public-company comparisons usually take a while to mirror changes in the broader stock market.

The Nasdaq began its current down slope in August, 2007, which means some late-stage startups that need to raise cash -- along with their investors -- soon may be facing some hard choices.

"There's usually a lag factor. Sometimes it takes at least several quarters or even a year," says Michael Patrick, a partner with the Silicon Valley-based law firm Fenwick & West.

"Late-stage financings are more driven by public-company valuations," says Patrick, whose firm has been tracking valuations for venture-backed startups since 2002.

That's not to say every VC firm or startup CEO, or even a majority of them, will be faced with the prospect of having to swallow a down round. 

Early-stage valuations are more insulated from public stock swings because they usually depend on how much money a company needs to raise and how much a VC firm needs to invest to keep their stake intact. Those VCs have a longer investment time horizon, so they can look past short-term market swings.

Startups in hot sectors like clean technology will still be able generate enough growth to drive valuations higher. Web 2.0 companies also are running leaner than free-spending dotcoms were during the bubble, which means they're better able to ride out the worst of the pain.

A growing secondary market for private-company shares could also help support valuations.

But we've already heard one investment banker predict that some cash-hungry biotech firms won't make it through the turmoil of the next 12-18 months. He's already seeing more VCs following their own investments in startups rather than take in new money at an unattractive valuation.

Recent history suggests there will be some pain even for surviving late-stage companies that need to raise cash during the next year.

While the Nasdaq peaked in March 2000, average startup valuations were still dropping more than two years later. 

The worst IPO drought in memory for venture-backed startups won't help because the lack of exits can spook late-stage VC funds that are looking to get cash out of their investments in a year or two.

While M&A activity remained healthy in the first half, look for the number of buyers to shrink as capital to finance acquisitions withers amid the market turmoil.

It's been several years since the average round for any stage of venture investment has gone down. 

Look for that to change soon.