Billion-Dollar Start-Ups Should Be Thanking the Federal Reserve
It seems like the list of start-ups valued at more than $1 billion just keeps getting longer.
Facebook (FB) is reportedly expected to offer the social mapping company Waze $800 million to $1 billion to acquire it.The room rental start-up Airbnb has been reported to be worth $2 billion and Evernote is reported to be at $1 billion.
The list goes on and on. But how exactly are these young companies reaching the billion buck mark? Well, they've had some help driving up their valuations from the Federal Reserve.
Fed Chairman Ben Bernanke has kept short-term interest rates near zero since 2008. While many expected rates would have gone up by now, rocky economic numbers have many speculating that rates aren't changing anytime soon. For young entrepreneurs, low interest rates can translate into easy funding.
Basically, securing large investments from private-equity firms is a lot easier when interest rates are low because the opportunity costs are low. Basic macroeconomic theory suggests that bonds are an alternative to equity investments, which include venture capital investments. When bond returns fall, the relative attractiveness of investing in venture capital funds increases.
Once you've locked in one private investor, well, it doesn't take very long for bidding to start to take-off.
In addition, because a growing number of high valued start-ups -- such as SurveyMonkey, which is also valued at more than $1 billion -- are focused on the enterprise market and not just consumers, taking a stake in a young company is lot more reasonable to investors because the business model is seen as less risky.
And yet, while it doesn't currently look like tech has reached the full-blown bubble stage, there is some disturbing behavior when it comes to later-stage investments in private companies that is becoming "frothy," said Bill Gurley of Benchmark Capital last month at the Disrupt TechCrunch conference.
"The late-stage private market continues to be the most frothy thing I've seen since the late nineties. And I thought it was going to go away when you had these iconic IPOs that ended up trading at a fraction of the private rounds, but it hasn't," Gurley said.
However, once the Fed takes away the massive liquidity it is putting into the system and interest rates head higher, it could have a negative impact on the venture community, Gurley said. That doesn't bode well for the start-ups looking for funding.
The easy money isn't as easy as it once was, said Sanjeet Paul Choudary, a venture advisor who analyzes start-up strategies.
During the three years leading up to the Facebook IPO -- from 2009 to 2012 -- investors were putting large sums of money into early stage start-ups because more conventional forms of investments, like housing, weren't profitable, he said.
But after the botched Facebook IPO, early-stage investing took a dive, Choudary said.
"Large investments at the early and seed stage pushed valuations up. But optimism has gone down in recent times," Choudary said. "There was a correction in the market."
A lot of the companies who received funding before Facebook's IPO didn't get later stage investments, he added.
Total U.S. venture capital investment has fallen for three straight quarters, according to the PricewaterhouseCooper report.
Overall VC activity slowed in the U.S. during the first quarter of this year with total investments coming to $5.9 billion in 863 deals, a 12 percent decline in funding and a 15 percent decline in deals from the previous quarter. The decline is likely because venture capitalists are having a hard time cashing out in their prior investments.
Since 2012 the number of VC backed exits has steadily declined.
However, you shouldn't read too much into the deal slowdown in the private market, said Tracy Lefteroff, global managing partner of the venture capital practice at PwC US, because there are positive signs that the deal market for tech is about to make a comeback.
"People have to remember the venture capital business is a cyclical business," Lefteroff said. "There have been tough times in space before, but one thing that continues to drive business is there is always a demand for innovative young technology companies and I truly believe that we will see a return very vibrant return to investment. This is just a bottoming out of the cycle."
Software companies that build their business model around enterprise are primed for more VC investments, he said. Not to mention that there are also some software company IPOs on the horizon, which will ultimately enable investors to reinvest more capital, he added.
With the market at all-time highs-up about 15 percent since a year ago and at its best start since 1999 -- investors are hungry for more risk.
"The thing that is propping up U.S. equities right now is interest rates being so low, anytime interest rates are so low, equities perform well ... so people are seeing liquidity," Gurley said. "The venture community has long been a trailing indicator to the Nasdaq, because it's a cyclical business."
However, while the long-term outlook for the VC business is good, investments in social networking companies that rely strongly on being the most trendy company do seem unrealistic, Lefteroff said.
"I don't see a bubble, but the social network genre has the potential to get out of control and frothy," he said.
-- Follow Cadie Thompson on Twitter @CadieThompson.
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