Start-up Bubble

Saturday. January 01, 2011 - 2 mins

A lot has been written in recent weeks about the bubble forming in the web start-up investment space, particularly around VC financing. The main argument asserts that valuations have grown beyond their rational level due to the exuberance of investors fighting to get into competitive deals. This is problematic because average VC returns have been fairly dismal for sometime. The other argument is that companies who lack a reasonable prospect of growing into viable businesses are funded purely because they operate in a hot space (e.g. local, social sharing). While both statements probably have some basis in reality for particular deals, the web startup space in aggregate doesn’t appear to be so frothy.

Less Capital, More Revenue

Before I decided to jump into the arena and start a company, I spent many months reading blog posts and listening to podcasts about the unique features of modern web start-ups. First, such companies leverage cheap or free open source (or web service) tools, allowing a small team to build a minimum viable product and attract users before seeking outside financing. Secondly, many (if not most) of these companies focus on monetization relatively early. In general, there’s a large focus on finding ways to get users onto your service (check the recent buzz around A/B testing) and methods to cover your small expenses.

The financing landscape changed in response to the needs of the modern, lean start-up. Since they require much less capital to reach early development / customer milestones, Angels / Angel groups / Super-angels now fill the space of $500k capital deals to a greater extent than they have in the past, while VCs participate in subsequent rounds or pursue companies with greater capital needs.

Start-up founders and Angels appear to be comfortable with this arrangement.

Investor Returns

All of that said, VC returns are too low*. According to a study completed by Cambridge Associates, ten-year Venture Capital net returns to L.P.s through July 2010 hover somewhere around -4%. Surely, that number comprises losses from the dot-com bubble era, but returns from recent years are not much better either (they’re small and declining)**.

It’s hard for me to see how a moderate reduction in valuations will significantly improve overall returns, however.

Lingering Questions

In light of consistently poor returns for the average VC firm, how will requests for more capital to their L.P.s be sold?

At a high level, I expect lower VC returns to lead to less (or smaller) subsequent funds. If the number of VC funds drops, the relative bargaining power of start-up founders will drop, which should reduce valuations at equilibrium (all else being equal). How should start-up founders negotiate going forward considering this reality?

What are you thoughts?

* Too low for the amount of risk inherent in the asset class.

** The return referenced pertains to the industry at large, not the portion investing in web start-ups.

I pulled returns from here:

References

Cambridge Associates LLC U.S. Venture Capital Index® And Benchmark Statistics

Crisson Jno-Charles

Fullstack Software Engineer specializing in Scala, JavaScript, and Java development