Why Startups Are Currently “En Vogue”
We’re seeing an over–perhaps irrational–exuberance in startups of late. From angel investing to microcap stocks, money is flowing into low-basis assets. The reasons are likely highly dispersed, but both macro and micro forces are at play here–including government regulation. Timing plays a huge role in the affinity or disdain for startups. Like any other stage of the business lifecycle, the interest in startups ebbs and flows. It just so happens that startups– and particularly tech startups–are currently having their day in the sun. What follows is a discussion as to why startups are seeing such great interest as well as a discussion on the sustainability of this trend.
Frothy Asset Valuations and Top-Down Startup Demand
I have a client in the SaaS space with an unhealthy addiction to TechCrunch. The daily TechCrunch feed has regular examples of $50M to $100M valuations on pre-revenue startups for things as novel as a mobile application. I recently advised the client to quit reading TechCrunch as it was skewing his view of reality stating, “TechCrunch is nothing more than engineering exuberance.” The deals published on TechCrunch are the poster-child for tech-sector froth.
Public P/E ratios and private company multiples are as high as they’ve been since 2007. Both private and public equity are exiting their funds en-masse. In fact, according to Preqin, Private-equity firms reaped $442 billion cashing out of 1,686 investments in 2014. Just this week we saw Bain Capital pull out huge amounts from Bright Horizons. The overall holding periods for private equity investments is as low as it has been in almost five years: down to 5.5 years from 5.9 in 2011. Everyone agrees that things are more frothy than they have been in a while. The affinity for startups certainly reflects this.
The froth tends to push firms toward investing in new ideas, including startups where they can receive greater returns from a small, but calculated investment in companies where the overall basis is low. It’s the age-old “build vs. buy” scenario. A particular buyer or investor will likely refuse to overpay for a target when they know they could build it organically for less cost, but we all know that’s typically easier said than done.
The bloviated valuations are also causing some to wonder: “is this the new norm?” Certainly, a market correction is warranted, but perhaps the higher valuations are something that many private equity buyers will be forced to deal with–at least in the short term. This is certainly something that will continue to have a meaningful impact on the demand for startup investing. I doubt the current demand level is completely sustainable long term, but a small market correction is likely not to wipe it out. No–the equivalent of an Internet or Housing Bubble event would likely be required to really tank the startup scene.
Cinderella Stories and the Bottom-up Groundswell
Everyone loves to hear the story of the underdog–especially the underdog. Statistically speaking there are many more underdogs in the world of business than there are profitable, successful companies. In other words, the masses will cheer on a Cinderella story because, whether we like to believe it or, we’ve all been there. We can relate. We’re America. We love the entrepreneur. We like to cheer them on, feeling that their success is in part a success for us all. Hence the love for television shows like Shark Tank.
In addition, the lack of wage rebound (not to mention the lack of overall job rebound) in the economic recovery since 2008 has many an employee, including the unemployed or underemployed, seeking alternative sources of income. This, in turn, is likely driving some of the startup demand.
The increase in remote working options has naturally driven the expansion of the startup scene. Sites like Freelancer.com and Upwork have contributed to the all-remote work force or at least the professional freelancer. So while asset valuations push startup demand from the top-down, other economic forces are driving the startup ecosystem from the bottom-up. It’s the perfect storm for the truly-experienced manager looking to 1) start something compelling and 2) garner investment dollars for doing so.
The Crowdfunding Effect
I would be remiss to completely discount the crowdfunding impact. Certainly at least a portion of the exuberance in the startup scene is due in part to the new crowdfunding legislation that is still gestating. With Regulation A+ expected to be in full-force in the next few weeks, many startup investors are expecting some of the latest rules for crowdfunding to have a significant, lasting and long-term impact on small business growth and funding. I’m one of them. The opportunities for sourcing capital will continue to be bolstered the financial tools and opportunities available through crowdfunding.
Whether or not the startup investing trend is sustainable at its current levels remains to be seen. I’m somewhat of a natural pessimist, but I’m hoping some of the macro trends as well as new legislation will continue to push entrepreneurs to find newer, better ways of providing products and services to customers.
About the author:
Nate Nead is the Founder and Managing Director of InvestmentBank.com, a firm dedicated to small business finance and capitalization. Nate’s experience flows from the investment banking world where he consistently has helped business buyers and sellers maximize value in the transaction process in buying, growing and exiting companies.