Nivi · March 4th, 2010
Thanks to George Zachary, a partner at Charles River Ventures, for sponsoring Venture Hacks this week. If you like this post, check out George’s blog and tweets @georgezachary. – Nivi
In my first post, A brief history of your investors (and their investors), I wrote about the history of venture capital. I described how the economy and stock market drives investments into venture capital and startups. I also covered how the basic incentive structures are affected by these drivers.
I ended with a suggestion that cash is gaining power relative to other assets and a suggestion that this will shift the balance of valuation and terms in favor of the root sources of capital (limited partners and above). In this second part, I’ll discuss why I think this is happening and what it means for venture investors and entrepreneurs.
Speculative returns are a major component of total returns
The coming decade is not going to be a bull like the 1980’s or 1990’s. Why is this important? Because it’s going to turn money into a “scarce” commodity and therefore drive down valuations, erode returns, remove under-performing venture funds, and reduce company exit valuations.
The 1980’s and 90’s were incredibly bullish. The annualized return from the public stock market was 16.8% from 1982-2000. That is huge. If you dive into the 16.8%, the fundamental return was 9.9% annualized.
What’s the remainder? I’ll call it speculative return. The speculative return was 6.9% between 1982-2000. And what is speculative return? It’s the expansion of the starting and ending P/E from 1982 to 2000. We started 1982 with a P/E of 8.0 and finished 2000 at 26.4!
As I wrote in part one, the increased supply of money drove these large returns. M3 money supply started its ballistic rise in the early 1980s. The total debt market went from $4T in 1980 to about $52T at the end of 2009. So the credit boom and decreasing interest rates fire-hosed cash into all markets. And that’s how a speculative return of 6.9% a year was driven. Other drivers included the baby boomer demographic, the technology boom, geopolitical stability, and the boom in international trade from globalization.
If we look back in time, the preceding time period of 1966 to 1981 had a total return of 5.9% (including dividends of course). However, the fundamental return was 11.1% and the speculative return was -5.2%! We started 1966 with a P/E of 17.8 and finished 1981 with a P/E of 8.0. And to add a little more color, the 1950-1965 post-WWII time period had a total return of 16.1%. That was comprised of a 10.0% fundamental return and a 6.1% speculative return. And, looking forward a bit, we can see the 2001-2005 time period had a total return of -1.3% with a -6.9% speculative return.
This data suggests that the speculative return component is a huge driver on total returns. And that it has a fairly long half-cycle time. It’s in the vicinity of 16-18 years if we do the analysis since the early 1900s. In a short 5 year period, speculative return can comprise 55% of the total return. And, over a 40 year period, speculative return drops to near 0%.
Benjamin Graham said it best when he said that the stock market worked like a voting machine, but in the long term like a weighing machine. If you are building a long term company, that is the good news. The not-so-good news is that the short term pain of being part of the voting machine could be very significant.
2001-2020 will have negative speculative returns
Okay, its 2010. Could the speculative return dynamics since 2001 have ended? Umm — probably not. Take a look at this table of important drivers that compare 1981 (the start of the mega 20 year bull period) to now.
| 1981 | Today | |
| CPI | 8.9% | -1.3% |
| 30-year bond | 13.65% | 4.24% |
| Fed Funds rate | 12.00% | 0.25% |
| Highest marginal tax rate | 69% | 35% |
| Highest LT capital gains tax rate | 28% | 15% |
| Home ownership rate | 65.2% | 67.4% |
| Household debt as % of income | 56.1% | 114.4% |
| % of families with retirement accts | 20.4% | 52.6% |
| Personal savings rate | 11.4% | 3.0% |
| Mortgage debt as % of disposable inc | 43.1% | 95% |
| Baby Boomer age range | 17-35 | 45-63 |
| Federal Deficit as % of Nominal GFP | 2.5% | 11.2% est |
| PCE (consumer spend) as % of GDP | 61.9% | 70.7% |
| US debt as % of GDP | 32.2% | 85.8% |
| Household debt as % of GDP | 47.2% | 96.8% |
To me, these are very sobering statistics. They paint a completely different picture than at the start of the last bull cycle of 1982-2000. My judgment is that these statistics are going to seriously suppress speculative return. The -6.9% of 2001-2005 will get worse and total returns will suffer. In 2021, statistics will show that the 2001-2020 time period had good fundamental returns. But horrific speculative returns.
Valuations go down and diligence goes up for startups and VCs
What will this mean for the U.S. entrepreneurs and investors? In short, we are not going to be “partying like its 1999” for quite awhile. (Who knew that the artist formerly known as Prince could forecast market peaks?)
The implications of negative speculative returns will be huge. The number of venture firms and their personnel will shrink. And probably hit bottom sometime this decade. Venture firms will be under significant pressure to outperform their peers and outperform their limited partners’ common benchmark indices like NASDAQ. Limited partners will feel the same type of pressure as they too source their capital from sources that will be under tremendous economic pressures. Angel firms (translation: angels who are institutionally backed) will feel the same pressure. Angel investors (individuals investing their own capital) will become more risk averse.
How will these pressures affect entrepreneurs? As a whole, valuations will stay suppressed and will probably come down further over the future years. Revenue multiples and “discount to public market multiples” will re-enter and dominate the late stage financing lexicon. Early stage companies will also feel this suppression with smaller venture rounds. Capital-intense startups that need to raise large initial Series A financing rounds will be particularly affected.
The amount of time spent in due diligence will go up and get more rigorous and detailed. Of course, there will always be companies that are exceptions. But as a rule, the suppressed return environment will force all parts of the money chain to spend way more time in diligence. Way more time and energy for limited partners to raise capital. And the same for venture investors. And the same for angel firms.
Startups will feel this diligence pressure next as they are the next stop on the money supply chain. My guess is that new service providers will emerge to help both investors and entrepreneurs with these diligence processes. How they will be paid is an open question.
Since individual angels use their own cash, they won’t be directly affected. But they will probably diversify their portfolio by making smaller investments on average. And put less of their total portfolio in startups so that they can have greater portfolio liquidity. In aggregate, they will put less money into startups.
Some startups and VCs are going to disappear
Okay, so valuations down and diligence up for every part of the money supply chain. We can all work through that.
Where matters are going to get tricky is that parts of the money supply chain will disappear. A venture investor or angel firm may run out of cash in a fund and need to raise a new fund. A startup company has a similar problem.
If you are a startup company, a pure non-dilutable asset is your time. Raising a new financing round requires time. Since we’ve already established that investor due diligence time will increase, the last thing an entrepreneur will want to do is spend that time talking with investors who don’t have cash to invest. Or who can only invest with particularly harsh terms because of their own liquidity needs.
In the next and final part of this series, I will detail the questions you should ask your potential investors. These questions will assist you in ensuring you are talking to the right investors for your company.
In closing, here’s the “New York Daily Investment News” front page from the early part of the Great Depression to remind us that history may not repeat exactly. But it does rhyme.
Topics Limited Partners · Sponsor · VC Industry
I am surprised that you are not somehow correlating people’s risk appetite with breakthrough innovation (and therefore reward). 1980 was the era of the PC. 1995+ was the era of the Web. You seem to imply that innovation is going to stop. I am not sure I agree. I think that cloud computing and mobile are about to tip in a very big way and we will have another 15-year run.
Hi Edwin — Actually, I am not implying innovation is going to stop at all. What I am implying is how the price of “money” is going to change and how that will affect investment into the startup landscape.
I do agree that cloud and mobile are huge. What my article is focused on is how the supply/demand of capital is driven by macro forces that are a combination of macro economy, socionomics, etc.
I see. Thanks for the clarification.
George,
What you are considering are averages, say, macro economic averages.
It may be that more in technology will give venture capital some really big gains no matter what the rest of the economy does, but I won’t try to argue that here.
I will argue: An individual entrepreneur and his investor know so much more about their particular project than the macro economic averages that the averages are for them nearly irrelevant. [LPs foolish enough to read the CAPM — listen up].
Or if a project has high promise of making money, then what everyone else is doing on average is a bit irrelevant.
The need is basically just to pick good projects, that is, ones that make money or clearly soon will. The rest is for ‘macro economics’.
For people who want to worry about the averages, if the economy is to move ahead on average, then some entrepreneurs will have to have to do the work, whatever it is, to do their part, that is, make their projects move ahead. Uh, we can’t all lose but make it up on the volume! Working hard and smart to get things done is an old story in the US! Some of us will do that whatever the macro averages. So, again, pay attention to the individual projects, one by one, which VCs do anyway, and dumpster the macro averages.
For the ‘due diligence’ (DD), given the rest of what an entrepreneur brings to the table, DD sounds like mostly time wasting: Or, maybe the evaluation is in terms of ‘traction’. Okay, show number of unique users per month, the rate of increase, and the same for revenues. Evaluating these doesn’t take a lot of DD.
But maybe the entrepreneur has crucial, core, unique, powerful, difficult to duplicate or equal ‘secret sauce’ that promises to be of crucial importance all the way to the horizon. GOOD. He SHOULD. For this ‘secret sauce’, what is the best approach? Sure, some high quality original research he has done and will NOT publish, publicize, or submit to the USPTO but just translate to software to run only on a server farm behind a firewall and locked doors. Yes, even in ‘consumer Internet’.
Haven’t seen a lot of examples? Right: Neither has anyone else! So, looks like an opportunity, for those who know how!
Now need DD for this research. The way that is done now is mostly just by a peer-reviewed journal of original research. For that need qualified referees who report to an area editor who reports to an editor in chief. The referees have good Ph.D. degrees and good research records in their fields and have been doing such research for, maybe, 10 years. After maybe 10 years of being a referee, they might become an area editor. After about 10 more years, Elsevier or some such might ask them to become an editor in chief. That’s mostly how DD is done. NSF also draws from essentially this same system.
For this DD work, how is a venture firm going to do it or even direct it?
Don’t ask me; I’m just an entrepreneur who does such research and wants to use it as the core asset in a powerful business and no longer wants to publish such things! What I suspect will happen is that the venture community will draw from A. Markov, conclude that (A) the research and (B) the financial potential of the company are conditionally independent given the present ‘traction’ data. So, to get a handle on (B), look at the traction data and then f’get about (A). This Markov assumption is not really correct, but it is what people do. Or, some research and a dime may just cover a 10 cent cup of coffee. So, given the dime, why waste time on the research DD? I don’t think people will, even if they want to!
For ‘consumer Internet’, there is another issue beyond DD: Already the common requirement for ‘traction’ means that a major fraction of entrepreneurs are close to not needing venture funding by the time they qualify for it. Then just why will a founder, who did the research, typed in the software with his 10 fingers, and did the rest to get the traction suddenly want a term sheet, founder vesting schedule, option pool, liquidity preference, and a Board that doesn’t understand the research or even the company and can too easily go all a-flutter and ruin everything? These are not really advanced considerations; I heard them in the first grade from the Mother Goose story ‘The Little Red Hen’.
I agree that the only way out of this is for something new to replace all the sectors that will be lost to the rest of the world. The only way to get out of this crisis is through innovation, and not sure what that will be. I’m thinking clean energy is a big bet, but the U.S. seems to be losing that battle. Not sure how big cloud computing will be.
Great post! It definitely sheds some light about what I’ve been thinking lately. I’m wondering though, if there are significant differences/trends when you look at specific sectors or geographic locations. Have disaggregated your analysis at all in either of these respects?
Hi Sachin — Thanks. I couldn’t get all the data at a specific sector/geo cut. So good question.
George — Don’t speculative returns simply represent how excited or unexcited people are at any given time coupled with the amount of money that the Fed “invests” into our economy? Shouldn’t the speculative return increase as interest rates are low and change with the Fed fund rate?
Jeremy — Good question. And the right line of thinking. You are right that a driver is the money supply expansion by the Fed, etc. But it’s only one of the drivers. The others have to do with life cycle earnings per capita, disposable income per capita, “excess” corporate earnings, etc.
However, interest rates are uncorrelated with market direction. That’s what the data shows over the long run.
Cash is rising in value, but it depends on how you define cash. If you mean U.S. dollars….not so much. If you mean gold, oil, and other commodities that may serve as monetary substitutes in the event of a currency crisis…yes.