Web start-ups are still given huge boots to fill

Bambi Francisco Roizen · October 29, 2011 · Short URL: https://vator.tv/n/2045

But signs are pointing to troubled times for many of them, as prices start sliding

If you're like me, you buy a couple sizes larger for your kids because you know they'll grow into them. But unlike kids, startups don't always grow into the boots they're given. 

Many of you know - there's a lot of them walking around today with pretty big boots. 

There's no doubt that valuations remain frothy these days. Yet there are signs the good old days of just earlier this year and 2010 may be coming to an end for some unfortunate companies.  

For one, Groupon is now pricing its IPO at $16 to $18 each for a valuation of $11.4 billion. This is slightly higher than the $9.5 billion price Growth Fund of America put on Groupon, and the $8.7 billion value assigned by T. Rowe Price Group  back in May. But it's also well below the $25 billion rumored IPO in March. 

Initially positioned as a startup poised to mint cash for the foreseeable future, the truth has become apparent that Groupon is not nearing a billion in revenue, but rather $312 million. Amazing, yes. But a big difference in expectations, nonetheless. 

Zynga, which was rumored to be valued at $20 billion this summer, has seen a slowdown in its revenue growth, and is showing signs of vulnerability with its significant dependence on Facebook. The risk of having a growth rate skidding to a halt is certainly reason to pay a price that reflects that risk. At $20 billion, that risk isn't priced in. I wouldn't be surprised if that valuation came down before they went public. 

After all, most companies and investment bankers would like a first-day pop. LinkedIn trades at $87, nearly double its IPO price of $45, when it debuted in May of this year. IPO's that stay above their debut price are always perceived to be more successful than those that fall below. While LinkedIn remains highly valued at $8 billion in market cap, with roughly $400 million in annual revenue, the rest of the market is pretty tepid, with some incredible exceptions, like Apple, which is up 22% from $322 at the start of the year. 

And, what happens to these lions at the top will trickle further down the food chain. It's like they say in The Lion King, it's a circle of life (we're all connected somehow).

To be sure, Silicon Valley seems to be operating in its own bubble, as it often does. Valuations remain unrealistically optimistic for some startups that just raised fresh funds. And, I'm not talking about the usual suspects, like Twitter, which raised $400 million last quarter, according to Dow Jones VentureSource. The pricetag was a rumored $8 billion valuation. 


Most of the companies above are mid- to later-staged companies, which is where a lot of the rich pricing is, say investors.

(Editor's note: Vator and Bullpen Capital will be discussing what's happening across the venture landscape during our Venture Shift NY event this Nov. 17. Join us as well as top VCs from GRP, First Round, RRE, FirstMark, TechStars and many more to explore what's happening. Register here.)

"There's definitely froth, but the risk is greater if you're investing in later rounds," said Jeremy Liew, Managing Director at Lightspeed Venture Partners. "It's not in Series A (as it really doesn't matter if you invest $2 million at $8 pre-money or $3 million at $12 pre-money to get 20% ownership), but in subsequent rounds."


Pinterest has a $200 million valuation, but has essentially no revenue; Tumblr has an $800 million valuation with little revenue to speak of. Airbnb is valued at $1 billion, but with revenue as little as $30 million - a 33 times price-to-sales multiple. Even Zulily, a commerce play, seems a bit high at 6.4x sales. Consider that Diapers.com (now part of Amazon) raised funds back in 2009 at $200 million, or about 2x forward-looking sales, according to an investor. 

Tumblr, a content company that doesn't own any of its content, is valued at $800 million. Compare that to Demand Media, which owns its content, and trades on the public market at a $500 million market cap (and that includes Demand's $100 million in cash on hand), and generated $158 million in revenue in the first six months of this year.

Now to be fair, many private companies are valued based on consumption and users, not necessarily whether they have yet to monetize. Facebook received an eye-popping valuation of around $100 million back in 2005, which makes this multiple analysis total garbage. Often it's just a gut instinct that tips an investor into doing a deal or not. Sometimes paying up is "what it takes to do the deal."  

And, commerce companies can often attract high prices because of the lightning-speed growth rates they can sometimes achieve. For example, ShoeDazzle's annual sales were $8 million in one year, and $30 million the next. Sales are expected to be $80 to $100 million this year, according to an investor who saw the deal. Still, today's prices reflect near-flawless execution. 

"A lot of valuations imply perfect executions and aggressive growth - that don't always materialize," said Jeff Clavier of SoftTech VC. "Valuations of early-stage companies compound what has been proven to date, and the potential of the business as well as the risk that investors are taking. The higher the valuation, the less this risk is compensated."
Record level seed investments

While risk isn't being compensated, many investors continue to put money to work anyway. 

Despite all the talk of a cash crunch (which I believe will happen but probably not for a year), investors continue to invest heavily in consumer Internet companies. Between July through September, venture capitalists put $1.3 billion into consumer Web companies, that's double what they did the year prior, according to Dow Jones VentureSource. 

Seed-stage rounds remain at high levels, as some $19 million was invested in this sector during the last two quarters, according to statistics gathered by Dow Jones VentureSource. The quarter also marks the highest amount ever invested in seed-stage rounds ever - even surpassing amounts from the bubble circa 1999/2000.  

The amount of seed funding invested in the nine months of this year has already broken annual records. And, the data is most likely undercounting what's really happening in the industry, but directionally, it's pretty accurate. 

What’s also particularly interesting about the third quarter is that $1 billion of the $1.3 billion invested went to later-stage companies. Adding it all up, more than $1 billion has been invested in later-stage companies for four out of the past five quarters. That's never happened before. What this means is that increasingly, investors are willing to take a smaller sliver of a surer thing. Is this venture capital investing? Sounds more like private equity and mutual-fund investing. Traditional venture capitalists take product risks. 

Why is this a concern? As Scott Austin, editor of Dow Jones VentureWire, observed: “If investors continue focusing on later-stage companies that would likely have exited years ago had market conditions been better, the hundreds of young Web start-ups that raised financing in the last two years will face intense competition for second rounds." 

Indeed, we're already seeing that VCs are having trouble raising fresh rounds. According to the NVCA, the amount of funding that venture funds raised in the third quarter was 53% below what they raised a year earlier. The total amount of $1.72 billion was the lowest raised since 2003. 

As we can imagine, this means that the tens of thousands of companies being funded at the earliest stages will have trouble finding fresh funds to stay afloat. Picture a whole bunch of angel and early-stage investors equipping a bunch of sailboats to get out on the water, only to end up with no wind - for a long, long time. 

"You have early-stage companies raising $150,000 to $750,000 quite easily," said Sam Angus, an attorney at Fenwick & West. "These companies have gotten an initial slug of funding to finish their product (much of that financing this year). But what happens when companies burn through that cash? How difficult or easy will it be for them to raise the next round? That's where the rubber meets the road."

Terms start getting tougher

The rubber may already be close to the road however as reality is starting to set in, though it's not so obvious if you're just looking at valuations. It's the small details that are being put into term sheets. Sure, an investor may agree to a ridiculous valuation, but they'll make sure they're covered on the downside. 

One term slowly starting to bubble up and be used is called "full ratchet dilution." It's a great term for a later-stage investor, but horrible for anyone who doesn't participate. It's essentially put in to protect investors, in the event that valuations come down in the future. 

So, if an investor buys a share at $1 today, and the value drops to 50 cents tomorrow, they get issued more shares and their stock price is re-issued at 50 cents, effectively diluting the rest of the owners more than a more common term, which is weighted average dilution. If there weren't concerns that prices are frothy this term wouldn't be used as often. 

Why is this scary? These terms aren't so great for earlier investors who are taking significant risks. 

When prices are rising, everyone is happy. But when prices hiccup, or worse tank, that's when things start looking ugly. It's particularly not so pretty for entrepreneurs, angels, super angels and micro-cap VCs. These are the guys who hold the biggest risk. Of course, it does seem fitting considering that they also have the biggest gain if a deal works out well. 

Let’s take an illustrative example (*This is an extreme example for illustrative purposes of the tension between oversized valuations and terms) of the risk early stage investors and founders take in overpricing these mid-stage rounds.  Say for example I’m an early stage VC that puts $500k in what looks to be a hot new social platform company.  The pre-money is $4.5 million, so I end up with 10% of the company.  Then let’s say our traffic really takes off and some super excited late stage guys come in, I’ll call them BoldVC.  In parallel, some more savvy mid-stage investors also come along, we’ll call them TypicalVentures. BoldVC offers us $25 million at a $100 million pre-money valuation. But, they want a 2x ratchet on participating preferred.  TypicalVentures offers us $25 million on a $50 million pre-money valuation, no ratchet, straight preferred. They take the BoldVC offer. We’re going to be a billion dollar company, no doubt – and issue a massive press release – we’re valued at $125 million – on our way to $1B.  

Let’s say though that our monetization takes longer to materialize, and then Facebook announces a shockingly similar feature, and things slow down.  We still have some good stuff, but BoldVC is getting a bit nervous, and it’s looking like it’s going to be tough for us to cut a path as an independent company.  Google calls and offers us a very nice sum - $75 million for a company with no revenue for a potentially obsolete product.  Sounds good, right?  We’ll in this scenario, which should have been a win for all, the overreach on the BoldVC round is now coming back to burn.  They are going to exercise their participation rights, taking $25 million, and then their 2x ratchet, for another $50 million – oops! – that’s $75 million!  Our brilliant founders, and brave seed investors end up with a whopping $0!

Had they forgone the $125 million press release and taken the straight preferred at $50 million, they’d own two-thirds of the acquisition price and our fund would have posted a 10x return on our $500k investment!  TypicalVentures took a lot more risk, and didn’t get much to show for it.  BoldVC took a lot less risk, but pocketed a healthy return.  Interesting to think about which is the better scenario for the founders and early stage VCs.

For later-stage VCs, however, they're totally fine. Is this the new investment model? High valuations with horrible terms? If late-stage VCs see that it's advantageous to drive up a valuation and get a guaranteed return, then what's not to like about this model for them? Nothing. But there's a lot not to like for everyone else.

I suspect scenarios similar to these (though not as harsh) are going to start happening a lot more if valuations remain this high.

It's no wonder that smart ealry-stage VCs like Union Square Ventures' Fred Wilson and Bijan Sabet of Spark Capital cashed out of a portion of their Twitter holdings. While I'm all for diversification, and perhaps their departure has a lot to do with personality differences, the move does make you wonder what they think about the outlook for Twitter. But it also makes you wonder what the new terms were. 

Like I said, these startups have big boots to fill. If past is prologue, there's going to be a lot of empty boots laying around. 

(Vator and Bullpen Capital will be discussing what's happening across the venture landscape during our Venture Shift NY event this Nov. 17. Join us as well as top VCs from GRP, First Round, RRE, FirstMark, TechStars and many more to explore what's happening. Register here.)

(Image sources: imbecile.me and flickr.com

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Bambi Francisco Roizen

Founder and CEO of Vator, a media and research firm for entrepreneurs and investors; Managing Director of Vator Health Fund; Co-Founder of Invent Health; Author and award-winning journalist.

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