Why Valuations are Ready to Tumble
We all know valuations are up. It's one of the many factors often cited as evidence that yes, we are in another dot-com-like bubble, fueled by excessive optimism over new technology and excessive money to fund that optimism.
Still, the numbers in this year's recently-released "Pepperdine Private Capital Markets Report" should give pause to even the most optimistic entrepreneur. "There's been a big jump in valuations from last year to this year," says Dr. Craig R. Everett, director of the private capital markets project at Pepperdine University's Graziadio School of Business and Management. "These valuations are just crazy."
Everett says higher valuations are largely the result of the Federal Reserve's efforts to keep interest rates low. With the employment market showing continued signs of strength, the rationale for high startup valuations could be tested sooner rather than later.
According to the Pepperdine report, the median pre-money valuation for a company receiving its very first round of angel financing is now $1 million, almost double the $550,000 valuation that same company would have been able to get a year ago. For companies somewhat further along, the median angel valuation is $3.5 million, compared to just $1 million that those same angels were willing to consider a year ago.
Venture capital firms have been just as liberal. The median pre-money valuation for a company receiving seed-stage financing from a venture capital firm is now $3 million. Last year, the median pre-money valuation was only $1 million. So-called early-stage venture investments are winning median valuations of $8 million, almost double last year's $4.5 million.
This would be great news if entrepreneurs were suddenly building startups far superior to those of a year ago. It's not happening. In fact, venture capitalists--the same ones who are awarding these sky-high valuations--say the quality of companies they're seeing has actually declined in the past year.
Instead, says Everett, valuations are being fueled by low interest rates. That might seem strange at first, because most startups aren't taking out loans. But private equity funds rely on debt, and those private equity funds are often the buyers for startups. In the private equity world, valuations are super-high because debt is cheap. "As these startups are being acquired by private equity groups, [the private equity players] are paying more," says Everett. "The higher valuations are just blowing down."
Interest rates won't stay low forever. On Thursday, payroll processor ADP said private employers added 215,000 jobs in November, well above economists' expectations of 173,000 jobs. That, along with other positive economic news, could be enough to convince the Federal Reserve to begin to wind down its $85-billion-a-month asset purchase program, which would surely cause rates to drift higher--and valuations to slide lower.