Public Market impact on VC valuations
I’ve been puzzled by the apparent correlation between valuation of early stage private companies and the valuation in public markets. I’m talking here specifically about companies with some revenue (may or may not be profitable), but that are still 3-5 years away from going public – in other words a big chunk of the companies looking for venture capital type funding in India. Although the evidence I have is mostly anecdotal, conventional wisdom is that when there is a bull market in equities, VC valuations (defined here as pre-money valuations negotiated between VC and founder) also go through the roof and correspondingly valuations get depressed during a bear market. Two thoughts immediately come to mind:
(1) If we’re in a bull market today, then the odds that we will continue to stay in a bull market three to five years from now (the average time for an early-mid stage company to get to an exit point in the public markets) is less than 50%. Conversely if we’re in a really bad bear market, the odds are pretty high that in 3-5 years the stock- market will be looking up. Granted this statement is somewhat unscientific, but most economies are cyclical and stock markets even more so (when measured over relatively short time periods, say 10-15 years or so). Of course if there is something fundamentally wrong with the economy then the bear market may continue for ever, in which case all of us have other, more depressing problems to think about! Even if you don’t believe that an inverse correlation between public market valuations today and 5 years out exists or is strong enough, I’d posit that it is certainly stronger than a direct correlation between valuation today and valuation 5 years out. That being true, it is strange to see situations where VCs demand low valuations because the Sensex is down and equally strange when an entrepreneur wants a higher valuation just because we’re in the midst of a bull market.
(2) In fact, the opposite may well be true. From an LP’s perspective, private equity investing should generate higher returns than investing in the public markets. The LP’s cost of capital (loosely translated into some kind of hurdle rate at the fund)for private equity funds is therefore higher. It follows that in a bull market the hurdle rate at a VC firm should be even higher to generate returns high enough to justify diverting funds away from the easy pickings of the public markets. That would in turn imply that VC’s should drive very hard bargains during bull markets, driving down pre-money valuations.
Granted this is a bit like corporate finance 101 reasoning, but am curious to hear if anyone has a different viewpoint
