Tech company valuations rising and falling

After the latest high flying startup acquisition where Facebook (FB) bought out WhatsApp for $19B the conversation about valuations going up flooded the twitter-sphere.

I find this hilarious considering up until this buyout there were signs all over of both valuations on the rise from publications such as Fortune and Pitchbook and an equal number of signs that valuations were on the decline from Tomasz Tunguz and Angel List.

So where is the truth? Are startup valuations headed into the stratosphere and is a dot-com style bubble setting up again in the tech space?

What I find particularly interesting is that Facebook made most of the purchase with their own stock. This fact seems to be getting minimal attention due to the attention being given to the value per user, value of WhatsApp based on some formal valuation techniques (DCF and so on). The reason this piece is important though is that it indicates Facebook thinks of its stock as having more value traded for assets like WhatsApp than cash. In other words Facebook thinks its stock is overvalued.

Does that mean it won't keep going up? Heck no... it can still keep going up if the demand for it keeps going up. It is a clear example of a company acting like its stock is worth more on the market than it should be though and this is an important component of thinking about valuations. Thinking about the fact that Facebook sees its price as being worth more than the cash on its books, it makes sense that Facebook is seeing its value as an outlier to tech stocks in general (which is really what Tomasz is talking about). Facebook sees its valuation as higher than the steadily declining overall value of tech stocks. By declining of course I mean stabilizing as a result of tech companies being in existence for longer periods of time. Leaving companies like Microsoft, Cisco, and the like to sway the tech sector of valuations down while high growth early stage startups can still skyrocket in valuation. At the same time the data that Angel List provides is that many companies are failing and thus there is a higher number of lower valuation companies in existence. If 7 out of 10 startups fail... that only leaves 3 startups out of 10 that even have a chance at higher valuations. So the increasing number of startups being created and funded skew the numbers a bit to make it appear as though there are lower valuations for even tech startups. While the ones that do go on to take later rounds, get acquired or IPO are indeed rising as we can see with WhatsApp.

Perhaps this post by Aswath Damodaran is helpful in understanding this a little further. The simple fact that companies like WhatsApp are racing past their competitors (when most of their competitors are failing) means that they have positive momentum and trading based on the momentum of startups is a technique that many are successful at doing.

So yes, valuations are mixed and those that break through the roadblocks of slow growth or lower valuations are catching a disproportionate amount of attention that is causing their valuations to skyrocket. There is more and more money chasing the few companies that are winners and fewer and fewer money chasing the plethora of companies that are stagnant or losing. This is demonstrated further by Tomasz's post that shows the number of tech startup IPOs is still less than the 2005 timeframe.

Rob Go outlines how Sequoia is taking full advantage of power law distributions and the guts it takes to take advantage of them to their fullest.

If you are an investor, this is important to keep in mind - VCs love how the power law works and are applying their capital in such a way to accelerate the power law. If you are investing in early stage companies in seek of astronomical returns you need to find deals where VCs will bring a company to astronomical valuations. If instead you are seeking investments in companies that don't have this barbel of astronomical returns and rapid failures, you need to seek opportunities that are going to avoid this trap.

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