When Expectations Converge

Yesterday, I posted on a VentureBeat piece covering the correlation between exit market conditions and venture capital company-building behaviour and philosophy; or lack thereof. The piece called for a back-to basics approach to venture capital, where investors are focused true partnering with entrepreneurs to build fundamental value over a traditional investment horizon (5-7 years).

In today’s post, I wanted to tackle the flip side of this issue; the notion that exit markets and general public equity market conditions also have an impact on venture investor investing behaviour. In my opinion, there are three things required for a healthful level of new venture investment activity; liquidity, valuation stability and convergence of expectations


Venture investors fundamentally sell two things; money and expertise in helping the real heros – entrepreneurs – create value. But in order to “sell” money, we have to “buy” money. By by money, I mean we have to fundraise and create a committed pool of capital to invest; a fund. If VCs can’t buy money, we can’t sell money. And right now, many VCs can’t buy money at any price. There are many reasons for this, although I won’t digress into those issues here. Suffice to say, the number of venture funds and venture capitalists is shrinking. And as funds move past their initial investment period, there is less and less liquidity in the market. In the end, this is healthy as many have made the case that the venture asset class has been over-capitalized. But regardless, if there is less capital available to venture funds, there will be less capital available to emerging growth companies.

Valuation Stability

The best proxy for valuation stability is public equity markets. Anyone who has been paying attention in the least knows we’ve had an extremely volatile twelve months. Venture investors don’t like investing in falling markets. Some refer to this as the phenomenon of “catching a falling knife”; not something you want to try, you might get cut. Point being, an investor can look “stupid” for making an investment at a valuation that is cut in half in six months by a falling public equity market. This affects the early stage less than growth and later stage deals, because there is a floor on valuation; you can’t go lower than zero. Early stage deals; particularly Series A rounds simply have less far to fall than their growth and later stage brethren. But when a business can be valued on metrics; multiples of EBITDA, revenue, subscribers, etc., as growth and later stage deals can, new investment activity comes to a screeching halt in falling markets.

The flip side often occurs in rising markets, entrepreneurs think valuations are going to continue to go up and they try to price their deals to implied future valuations as if the market were guaranteed to go up. Point being, both falling and rapidly rising public equity markets can impede new investment activity.

Convergence of Expectations

The final requirement is a convergence of valuation expectations. When markets have recently fallen, investors adjust their valuation requirements down faster than entrepreneurs. And when markets have recently risen, entrepreneurs adjust their expectations down faster than investors. After a down market, entrepreneurs may “wait it out”, refusing to come to grips with the new valuation reality. And in an overvalued or over-bought market, investors may “wait it out” waiting for the bubble to burst or a correction. Again, this applies more to growth and later stage deals than to the early stage, although all stages are affected to some degree.

So where are we now?

I don’t know, but I do have an opinion; no surprise right. I think we’re entering a period of significant deal activity. There is a low, but appropriate level of liquidity in the venture asset class. We’ve come through one of the biggest stock market corrections in history and are now up greater than 50% from the bottom on all the major market indices. Valuations are stabilizing. Entrepreneurs have had the time to adjust to the new valuation realities and investors don’t have an argument that they are either catching a falling knife or that we’re in a bubble. It all sets the tone for a reasonable and balanced valuation discussion between investors and entrepreneurs.

I for one am glad to have a new fund to invest in this environment. I think it is going to be a great time to invest and to build strong, growing and profitable operating companies that can stand-alone for years to come.

Derek Pilling is a Managing Director at Meritage Funds, a growth equity firm. Derek invests in technology-enabled services businesses in the Internet Infrastructure, Cloud Computing, Digital Media and SaaS sectors.Derek lives in Denver with his wife and his three children. In his spare time, Derek enjoys coaching youth soccer, skiing, hiking, spinning and hopping on his rowing machine in the morning.

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Posted in New Investments, Risk, Venture Capital
Derek Pilling

About Derek

I'm a Managing Director with Meritage Funds, a growth equity investment firm based in Denver, CO. I've been working with growth stage businesses my entire career. When I'm not working, I ski, spin, coach youth sports and spend time with my beautiful wife and three kids.

I blog because the process helps me crystalize how I frame the world. I want to hear what you think. Please comment.

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