Will Token Markets Pop the VC Bubble?

Michael Ippolito | August 26, 2018

Warren Buffet made headlines back in May when he called bitcoin 'rat poison squared,' but crypto wasn't the only asset bubble that the Berkshire team was taking aim at. Back in January of 2018, before Buffet's now infamous comments on bitcoin, Vice-chairman of Berkshire Hathaway Charlie Munger had some characteristically sharp words for venture capital.

On CNBC's squawk box, Munger compared the current frothy venture environment to the dot-com bubble in the early 2000's. When asked if he thought bitcoin was a bubble, Munger replied, "Yeah sure, and venture capital too. There are always bubbles.... that are going to end badly."

Many have dismissed Buffet and Munger's comments on crypto as grumbling from an older generation of investors with a well documented aversion to tech investing. Munger's comments on venture capital are a bit harder to ignore though, because they aren't focused on the efficacy of new tech (i.e blockchain).

Instead, Munger based his criticism on the amount of capital being tossed around in VC and the sky-high valuations of early stage ventures. And when one of the most successful value investors alive begins to raise concerns over fair value of ANY asset class, it might be time to start listening.

 

The Venture Bubble by the Numbers

It isn't just Charlie Munger who's raised concerns over lofty valuations in the venture space. Legendary investor Steve Blank, informally referred to as the 'Dean of Silicon Valley,' had even harsher words for the current state of VC.

"VC's simply won't admit they're in a giant ponzi scheme," said Blank in an interview with INC. "And then, they have to play along because they've taken money from their investors, and their investors expect a certain return, but it's no longer an honest game. That's why it feels like 1999 again."

Similar to the dot-com era, investors are beginning to pay attention to non-cash related growth metrics such as daily active users instead of revenue growth and profitability. Many of today's so-called 'unicorns' aren't even close to being profitable, despite sky-high valuations and media fanfare.

Let's take a look at Uber and AirBnB, two darlings of Silicon Valley. In 2016, Uber received a $50 billion valuation, an eye popping 100x multiple of its revenue (to say nothing of its substantially negative EBITDA). AirBnB's $25 billion valuation seems cheap in comparison at a valuation of roughly 28x sales. More recently, San Francisco-based scooter startup Bird became the fastest company ever to raise $100M for a $1 billion valuation, which they doubled in just 4 months to $2 billion.

In the first half of 2018 ending June 30th, venture-backed firms have raised a whopping $57.5B dollars. That's more than any full year's worth of capital from 2008 - 2013, and a 50% increase from 2017. To give you some perspective, that's $15 billion more than the $42 billion that was raised in the second half of 2000.

The situation is maybe best summarized by a recent report by Pitchbook: "To say capital availability is high would be putting the true state of the VC industry lightly."

VC Bubble Graph

 

What Are the Causes of the Bubble?

There are a couple potential root causes for the explosion in venture capital over the past decade.

1. Access to Capital - Since the financial crisis of 2008, policy makers in the developed world have kept interest rates at historic lows to incentivize growth, primarily through investment. While QE has arguably been the driving force behind what is now the longest secular bull market in US history, it's had some potentially negative side effects as well. USV's Fred Wilson explains:

"I learned in business school that the multiple of earnings one should pay for a business is roughly the inverse of interest rates. The reason for that is if you buy a business that makes $10mm a year and pay $100mm for it, then you are effectively getting a yield on your investment of 10% (annual earnings/purchase price). This math is terribly simplistic but fine for the purposes of this post.

If interest rates are 5% instead of 10%, then you would pay $200mm for the business ($10mm/$200mm = 5%). So the math here is interest rates = annual earnings/purchase price. Again this is very simplistic because it does not deal with the important questions of what interest rate you use, how you deal with earnings that are growing or declining, and a host of other issues. But at the end of the day, this math [annual earnings/purchase price = yield] is fundamental and everything about asset values, capital markets, and valuations stems from it."

The takeaway is the cheaper capital is, the higher valuations need to be for investors to achieve an acceptable return on investment.

2. Focus on Non-Cash Metrics - Back in the dot-com era, it was eye-balls, now it's daily active users. Just take a look at Netflix, a company valued almost exclusively on A) domestic subscriber growth and B) international subscriber growth.

In Q1, Netflix posted revenue and EPS slightly below and in line with expectations, respectively, but jumped over 18% because of massive subscriber growth. Free cash-flow during that period? Negative $287 million. And yes, I understand the idea of content as a moat and room for pricing optimization but as of right now, today, Netflix is losing money but has a PE multiple of 144.

Steve Blank argues that today's VC culture has shifted from a focus on sales and profit to growth and disruption, which is not guaranteed to result in monetary value. According to Blank, "there was an unspoken but pretty solid rule: We needed five consecutive quarters of profitability and increasing revenues to go public. The role of venture capital was to teach you how to turn your idea into a profitable company. The role of venture capital now is the greater fool theory."

3. Misaligned Incentive Structure - The 'greater fool theory' Blank refers to in the previous statement is a reference to what HBR has called 'structural economic misalignment' within venture funds. To demonstrate what Blank is talking about, let's look at the hypothetical VC 'FundX.'

Let's say FundX raises its first fund of $10 million with a lockup period of 10 years for investors. For the sake of simplicity, let's say FundX decides to deploy all $8 million of its capital (because $2 million is reserved for the fund managers at a 2% of committed capital annual fee) into two companies, $4 million each.

With all of FundX's capital deployed, it's time to start raising a new fund, this time targeting $20 million. The first question potential LPs will ask? What were the returns on the previous fund.

So now you have a structure that earnings growth for VC's (i.e raise a bigger fund so that 2% management fee continues to grow) is based on the performance of the last fund they raised. And, luckily for them, in an environment where no one is paying attention to sales or profitability, all they need to do is find another investor that's willing to contribute some of their capital at a slightly less attractive valuation.

That fund is happy to allocate some money because they're in the same position as the first investor, and understand that all they need to do is find another investor who's willing to step in at a slightly higher valuation a couple years down the line.

And that's all well and good if the companies succeed, the issue is that many of them don't.

What happens, for instance, if one of FundX's $4 million portfolio companies begins to stumble? Maybe the business model is inherently flawed, or market conditions have changed in such a way that it's no longer a viable enterprise. What does FundX do? Do they pile more resources and attention in to fix the problem or declare a loss?

The answer for most funds is neither. They go out to find someone else to pour more capital in, this time at a higher, $8 million valuation. So that loser they just had on their hands? That's now a 2x return. And if the company eventually goes bust, the VC's still get their 2% fees and their LPs are left holding the bag.

The problem is that with private companies there are no systems for checks and balances. Private enterprise valuations are not set by the market, but by VC's who require stellar past performance to raise their next fund.

 

Token Markets to the Rescue?

One potential 'check' for bloated valuations could be a robust secondary market for private shares. History has shown that markets are a far more effective tool for price discovery than a small group of experts, so if private shares could trade like public shares there would be a second, potentially more accurate indicator of value.

So what does tokenization have to do with this? Simply put, tokenized private securities has the potential to create such a marketplace through 1) increased liquidity, 2) cost efficiency and 3) reduced prohibitions on the transfer of private securities. How does tokenization solve these problems?

1. Liquidity - As a result of the way our current financial system is set up, many investment opportunities are not accessible to all participants in the global market. In the world of private investments this can be for any number of reasons: geography, logistics, knowledge, or (as is often the case) your level of participation in the financial system (aka, being 'in the know'). Accessible participation for anyone with an internet connection increases the size of the investor base, and increases the ease of connecting buyers with sellers.

2. Cost Efficiency - One of the costs associated with transactions of private securities is the repapering of the transaction. The price tag for repapering can run anywhere from $5,000 - $50,000, which pretty much guarantees a large transaction size and excludes many potential buyers from the table. Making private shares digital would eliminate this cost overnight and lower the trading barrier for market participants.

3. Reduced Prohibitions - There are organizations such as Harbor and Trust Token currently working on solving the 'who, what, and where' of compliance for transfers of private securities. You can read more on the details here, but the outcome is a immaculate cap table that will allow private securities to trade to the limit of market conditions.

 

Why Token Markets Matter for Venture Capital

Let's take the recent example of electronic cigarette distributor Juul, who recently raised $650 million dollars for a valuation of $15 billion. That represents a valuation 56 times more expensive than their first round of funding in 2015.

Now let's imagine that a robust secondary market for private shares in Juul exists, but maybe those shares were only trading at a price that implied a valuation of $10 billion for Juul? What would that say about the true value of Juul?

Crypto has been identified as a threat to venture capital before, but that has been within the context of ICOs and a new, less restrictive model for raising capital. I think something interesting to watch would be the effect that markets for tokenized shares of private enterprises has on private ventures. At the very least, it may help keep them a little more honest then they have been.

 

 

 

 

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Michael Ippolito

Co-Founder of BlockWorks Group