Why Declining Startup Valuations Are Healthy

Believe it or not, some startups are still trying to raise money at 2015 prices.

These founders don’t realize (or accept?) that the situation has changed. Capital is becoming risk-averse. And for fairly good reasons.

It’s easiest to see this shift in the stock market, where things have been a bit rocky. S&P 500 earnings dropped in 2015 versus 2014, after a long string of rising profits.

And today, there’s no new Fed quantitative easing to goose the markets higher (for now). Further, many have argued that a diligent central bank should have normalized interest rates years ago.

Valuations are extended, and have been for a while. Take a look at the Russell 2000, which now trades at a price-to-earnings ratio of 111. A “normal” P/E for this small cap index would be 20 to 25, roughly.

Now let’s look at some private market data.

Private Market Slowdown

According to data from AngelList, average startup valuations on its platform dropped from $4.9 million in the third quarter of last year to $4.2 million in the fourth quarter.

In addition, overall venture-capital funding volume fell 30% from Q3 to Q4, according to CB Insights.

Both are interesting data points, but the drop in startup valuations is what stands out to me. It means that investors have essentially declared the right to be more picky. Funding volume is more of a lagging indicator, because it depends on funds that were mostly raised months or years ago.

Savvy startups are doing the right thing by lowering their prices if the demand isn’t there. Others are raising “flat” priced rounds, as Haystack Fund’s Semil Shah discusses in a recent post. Neither is an easy thing to do, because a flat round suggests no progress has been made (even if it has). And nobody likes a “down round,” where existing investors’ share value can be cut in half – or worse. Yet this is where we are in the cycle.

It’s clear to me that the market is in “Risk: OFF” mode. That could change. But for now things are a bit tighter, and it seems like they may stay that way for a bit.

Painful Transition, Healthier Markets

The transition from a raging bull market to a slowdown is painful for some, but necessary and healthy. Valuations had gotten a little out of hand compared to historical averages.

It happened fast, so it’s no surprise many founders didn’t notice.

As a result, there are a lot of young companies out there teetering in limbo. The last money they raised was probably at a higher valuation than people want to pay today.

If the startup is taking off like a rocket, no problem. They’re likely to get a nice bump in the company’s valuation regardless.

But if they haven’t nailed their product yet, that can be a difficult spot. More startups in this “pickle” scenario will fail if the funding market stays shaky.

Good for Investors AND Founders

Importantly, a return to reasonable private company valuations is good for the system as a whole.

In the long run, inflated prices hurt not just investors, but founders too. For example, many of the companies that raised money nine to 18 months ago are now seeking further funds. Their “next round.”

Problem is, investors have gotten a whole lot choosier in a very short period of time. Many startups are having trouble justifying their previous valuations, let alone the price they want to raise money at today.

This is how inflated prices hurt the entire system.

So as we prepare for the widespread launch of equity crowdfunding, I’m relieved that the startup market has pulled back a bit. It would be a shame if hundreds of thousands of new private market investors came into the market at a top.

So while the transition can be painful, there is a silver lining to market mayhem. It brings asset prices back down to reasonable levels. Put another way, it directly increases potential returns.

Another interesting effect of market tightening is that more startups are seeking “alternative” financing for their businesses. Many of these companies will turn to equity crowdfunding in 2016. I expect to see some high-profile deals this year. And we can all be thankful for that.

We’ll keep you in the loop as these deals begin to materialize. If you haven’t seen last week’s article about Virtuix, the virtual reality startup gearing up to raise money through equity crowdfunding, you can read it here.