In 2016, expect what has already become an increasingly difficult funding climate to become even more challenging. Thus far, fintech has been immune to this but there are cracks starting to form even in the hottest sector in startupland. The trickle down effect has led to difficulty even amongst VC darlings and the white-hot bitcoin and blockchain segments as well. This post will explore what has happened to cause value compression in startups and why it is leading to compression all the way down the chain (pun intended).

Valuation Compression

Throughout startup land we are starting to see valuation compression. Some of the darling companies of days past have suffered from down rounds (Foursquare), the effects of ratchets (Chegg & Square), going public at prices lower than their last round of funding (Square), being acquired at prices much lower than their last round of financing (Good Technology) or their valuations being written down from where companies invested in them (Snapchat by Fidelity). Read here for the effects of ratchets on both Square & Chegg. These are all symptoms of valuation compression.

Valuation compression can occur for many reasons. In times of easy money, investors are willing to invest large amounts of money into companies at friendly valuations, multiples expand and this trickles into all startups as whole. Essentially companies raise money at the valuations they want and this leads other companies to raise at these levels or higher. Investors begin to have fear of missing out (FOMO) and want to get a piece of companies in hot sectors. As more money flows and valuations rise, the expansion continues unabated, until it doesn't. Private markets follow public markets (or so the theory goes) and as those markets deteriorate or get shaken (as they have been since China devalued the yuan and the Fed raised interest rates) questions start to arise throughout the whole capital spectrum. This is when VC's and other investors start questioning business models, wondering how companies will make money and looking at the global macroeconomic environment and start wondering if the good times are coming to an end. The real question becomes what is company X really worth and is the industry it is in as a whole really as big as it once appeared. Are there too many companies competing for too little pie? The answers to these questions are inevitably always yes and that's when the consolidation phase begins but it starts with multiple compression and ends with funding becoming harder and harder. Warnings of a bubble have been heard for years and have gone largely ignored except within the media and some circles. (I am not saying a bubble has formed.)

It all starts in search of returns and money flows to where it can make money. VC's are always the first ones in and have benefited the most from the spectacular rise in private company valuations. Then a funny thing happened on the way to the theater; hedge funds like Tiger Global, financial institutions like Fidelity & T.Rowe Price started investing in late stage rounds for private companies because they saw opportunities they weren't getting in their other business lines and the public markets. This to me is where the beginning of valuation compression started.

Even some closed-ended mutual funds were formed to capitalize, companies like GSVC Capital (GSVC). GSVC invested in companies like Twitter and Facebook before they were public. GSVC defines itself as:

"externally managed, non-diversified closed-end management investment company. The Company's investment objective is to maximize its portfolio's total return, principally by seeking capital gains on its equity and equity-related investments. It invests principally in the equity securities of venture capital-backed emerging companies. It seeks to deploy capital primarily in the form of non-controlling equity and equity-related investments, including common stock, warrants, preferred stock and similar forms of senior equity, which may or may not be convertible into a portfolio company's common equity, and convertible debt securities with an equity component. It seeks to acquire its investments primarily through Private secondary marketplaces and direct share purchases, and direct investments in private companies."

With such successes in its portfolios you would think its stock price would be up in this boom for private companies. Ummm not so much. In fact it trades way below Net Asset Value (NAV). This is commonly referred to as trading at a discount and while there are many reasons for this it's generally not a good thing unless there are extreme market distortions( not to be discussed in this blog post). Below is a chart of the performance of GSVC since it first started trading.