All is not dire in sunny California

Dateline: Menlo Park

“The whole tech sector, flush for years with confidence and talk of disruption, suddenly has an air of desperation about it.”

Time Magazine, Nov. 12/15

Is that a cliff, just ahead? You’d certainly think so.

You’ve likely read the recent MSM news about Silicon Valley layoffs and the downward pressure that is building on technology valuations. When you are sitting in our Menlo Park office, as I was last week, it doesn’t seem quite so bleak.

Indeed, the breadth of the menu of free meals being offered at some tech ventures has been reduced. That the median valuation of venture fundings dropped in Q4 was widely foreseeable last September, given the sub-par IPO performance of quality tech companies through the first eight months of 2015. What else would one expect? And the shuttered IPO window has meant that the tap has been turned off for the mega passive follow-on equity rounds that once propelled the valuations of “Unicorns”, such as Palantir and Uber.

Historically, the pain resulting from a drop in private tech valuations has been primarily shouldered by venture capitalists. But oh, how times have changed. If you are a Unicorn tech CEO and wanted to raise $150M or more for your business, that capital isn’t all going to come from your traditional venture capitalist. You have had to rely upon the financial heft of the mutual funds (such as Boston-based Fidelity) or the wealth management arms of Goldman Sachs or Morgan Stanley. For much of 2012-2015, these investors have been buying the private shares of VC-backed private companies in anticipation of a near-term IPO. (It worked with Facebook and Twitter, went the thinking.)

The Unicorn crowd wanted to seed brand name mutual funds with pre-IPO stock on the expectation that these same Portfolio Managers would be the lead buyers on an eventual NYSE or NASDAQ offering. Once the U.S. IPO market soured last summer, preceding the current gloomy mood of the global capital markets, the late stage buyers of private tech shares went away. All of which has been the death knell for the lion’s share of the high profile “uprounds” that has dominated media coverage of Silicon Valley over the past 24 months.

As with all market moves, the reversal has been quick.

Mutual fund companies are now writing down some of these same private Unicorn tech holdings to reflect: i) longer than foreseen hold periods, ii) a decrease in the value of public company securities (the “comps” to their private holdings) in the current Bear market, iii) down rounds by similar companies within the privately-held sector, and/or iv) a disproportionate number of pulled IPOs during the second half of 2015.

This makes good grist for Bloomberg Television, and mutual fund unit holders might be sullen, but I don’t see the same kind of carnage pending as we in the tech sector went through 15 years ago. At least not yet.

In many ways, the sector is still set-up for success.

The recent tendency of larger equity rounds means that most companies are better capitalized than at the beginning of this century — given them a better chance to eventually reach cash flow break even. Higher valuations have meant that founders own more of their companies than they otherwise would, which nullifies much of the pain of a “down round” should one be required in the future. The regularity of large Secondary rounds as part of a traditional financing has meant that entrepreneurs have banked some cash, which can be used to seed their next idea if this one flames out. And, make no mistake, the fact that the last 20 years of VC investing has produced the likes of Facebook, Google, Tesla and Twitter, for example, reminds pension plan investors of what’s possible. There will be no talk of Pets.com when VCs go out to raise their next fund.

I know that the magnolias were blooming, and that might have something to do with it, but despite what you’ve been reading and hearing, all is not dire in sunny California.

MRM