Hitesh Kothari is an audit senior manager in the Financial Services Practice at McGladrey, focusing on the alternative investment industry. He has over 15 years of experience in public and private accounting, with over 10 years of experience in the financial services industry. We sat down with him to chat about recent trends in the venture capital space, including valuations, fundraising and more.
VC activity was down by round count but up in total value in the first half of 2015. Is this a function of high valuations or perhaps some other reason?
There has been a slight drop in the number of funds raised, but capital invested was up in the first half at $19.6 billion compared to $18.6 billion YoY. There’s been an increase on the buy side because of investment in large size funds. It’s true that investment sizes are going up while the total number of deals is coming down as right now the investors prefer to consolidate their deals and invest in growing, expansion stage companies. That’s where they’re most comfortable. Their perspective has shifted in the last few years and there’s more redeployment of their funds in these kinds of companies as they have less of a gestation period in terms of their exit.
Valuations have been high for Series B and later series of preferred stock, and that’s had an effect on overall entry prices across the board. Series A rounds have increased in valuations, but not astronomically like they have for the later series of financing rounds.
I don’t know how hesitant investors are because today’s companies could become the next Facebook or Twitter. We never know. There’s a lot of excitement in the tech space right now, and investors don’t want to miss out on these potential winners. And there have been some good exits in the social media space in the recent past, and investors want to make the most of the current crop of companies coming across their desks. They feel a need to redeploy some of their profits into these younger companies.
Discussions around valuations are usually about entry prices and whether VC assumptions are justified. With exits starting to fall, though, should the discussion pivot to the all-important exit window, which appears to be in decline?
In terms of value, exits have dropped globally, but if you look at 2014, last year was a record year since the dot-com bubble. And we should expect to see some correction this year and in 2016, as well. Many fund managers have entered into these industries at higher entry prices in Series B to Series D rounds, so they don’t want to exit unless they achieve acceptable ROIs. They’re looking for buyers that will give them a premium and aren’t going to settle for exits that only break even.
The third quarter will tell us quite a bit about where things are going in terms of exit and how the M&A deals and the IPO market is reacting to these new companies and technologies. This may very well indicate the trend for the exits in the fourth quarter, which historically has seen a spurt in activity in 2013 and 2014.
Globally, 91% of VC funds that closed in 2Q hit or beat their targets, the highest ratio since the financial crisis. What’s behind the improving batting average for VC fundraises?
Most of the new VC funds that are closing are focused on the tech space. LPs have met with a lot success in recent years, and that has increased their confidence that these new funds are going to find a couple of winners over the next few years. Recent IPOs have performed pretty well. 2014 was a great year for VC funds, and that has propelled LP confidence in this asset class, with the profits that were earned last year being re-harvested in new companies and new technologies. This new euphoria in the VC market has helped the VC funds beat their targets for new fund raises since the financial crises. Also the average time of the VC funds from its launch to its first closing is the lowest since 2011 at approximately 11 months in second quarter of 2015, compared to 20 months for the same time period in 2014.
Are you concerned about today’s tech valuations?
Valuations around tech startups are mostly based on the recent round of financing. When new investors come in paying X, that becomes the benchmark for the company’s equity value. The recent round of financing can be used as a valuation methodology for a short period of time of six to 12 months. It is difficult to perform due diligence by the new investors, especially for companies with little revenue. It’s not easy to value those companies, especially using the usual metrics, like revenue and EBITDA, and present value of future cash flows.
Many of these companies are in nouveau industries and have new concepts, so they don’t always have reliable market comparables. Valuations are normally based on investors coming in at the latest round of financing using the venture capital method. We need to be a little more cautious around using this approach to valuations if the company has issued different series of stocks that are not pari-passu and differ in seniority, liquidation rights and preferences. This valuation should be supported by a market model, like a Black-Scholes option pricing model or another market approach model, to verify if the enterprise value based on the venture capital method is in line with the market approach model.
2016 will be a bellweather year. By mid-2016, it will be useful to see how these companies are doing and what kind of exits they’ll achieve. Are the valuations of these companies really justified? I think we’ll have a better sense of that this time next year.