After having returned from vacation last week, I had the chance to reflect on the current venture and investing market. Yes, one of the big challenges is that there is still way too much money sloshing around in alternative assets. As I think about how to make money in this competitive environment and where to make new investments, I keep coming back to the thought that there is still opportunity very early or very late in a company’s life cycle. On the late side, the tech sector is clearly maturing, growth is slowing, and forward P/E ratios relative to the S&P are pretty equal or even less indicating strong value. Combine this relative value with the fact that many tech companies, particularly large software companies, derive 50-70% of their revenue from annual recurring maintenance and you have an opportunity to buy out many of these businesses due to their predictable cash flow. I see this as a trend that will only accelerate in the next few years as you have venture funds, LBO shops, and even hedge funds get into the tech buyout action. Witness the recent Sungard deal and others. If the private investors are willing and able to pay $11.3b for a company then no public software company is sacred. This includes companies like Siebel and BMC who both recently missed their earnings targets. There is plenty of value left in these software companies that the public does not see, and therefore plenty of money to be made by smart investors.
On the early side, I continue to believe there is much innovation to be done. As the VC funds get larger and larger, they are under increasing pressure to put more dollars to work in every deal. Therefore, it remains quite difficult for the larger funds to dole out money in $2-4 million chunks, and the valuations are quite attractive at this stage. As a fund, we typically like to lead or co-lead the first institutional round (post-angel) where the company has a strong entrepreneur, innovative technology, and a handful of customers to prove the market need. Where I do not want to be is in a Series B or Series C round in a "hot, momentum" company. I have had a number of these companies come through my door, and I keep asking myself how a company which is only a feature of a much larger offering will create a significant return for the fund after having raised too much cash at too high a price. When I see "hot" companies with revenue less than $5mm raise capital at $50mm pre-money valuations, I start getting worried, and it further reinforces my thinking on where to make good investments.
In the end, making good investments is predicated on taking advantage of inefficiencies in the market. As we look at every new deal, we always revert back to the lesson that Warren Buffet’s mom gave him, "Buy low and sell high." This includes investing on both sides of the barbell, very early with innovative technology in new markets and very late with established, out-of-favor software companies throwing off good cash flow. Considering that I am an early stage VC, I will have to play the later part of the barbell with personal investments in the public markets.
I agree, as example … one of my clients received a first round valuation of $3MM, on the B round the firm is expecting a $50MM valuation based on recent discussions with investors. Granted this is a Biotech firm with significant potential, but they currently have no clients or revenue sources.
Certainly the ROI potential decreased significantly for B round investors, but to be fair… so did the risk as the company’s process for gene decoding provides the industry with a significant cost reduction over existing methodologies and the downside for lost of principle is minimal at this point.