Archive for July, 2011

A Guide to VC Valuations and Tech IPOs

July 26, 2011 1 comment

With the recent tech IPOs suggesting the possibility of a bubble (and AirBnB now getting an investment valuing it at $1.3B), it may be useful to look back at how they got there. Most tech startups go through the venture capital system. The model is for the entrepreneur to:

  • Start off doing a little bit of work or market research themselves
  • Get investment from friends and family to buy 3-12 months
  • Get angel investors to pitch in just enough to cover another year or so to build something that’s real but not ready
  • Get anywhere from 1 – 10 rounds of VC investment, each time giving themselves 12-18 months of cash
  • After 5-7 years (ideally), have an IPO or sell to a large corporationĀ  (the entrepreneurs may own 5-20% at this point)

One of the big things investors look for along this process is increasing valuations; if a company ever takes an investment that’s not at a higher valuation than the last one, they’re in the penalty box and they’ll find it harder to keep playing. To make things easier some early angel investors use a structure that doesn’t assign a specific valuation but otherwise the game is to push the valuation up each time.

In the early stages nothing is standard; small investors will do things differently and take big risks. Once you get into the VC stage it’s a well-defined process that is openly talked about now. It’s estimated that only 10-20% of VCs really get good returns, but they all follow very similar models. One of the key parts is betting on big wins. The general idea is that for 10 investments, 1 will make great returns, 3 will break even, and the rest will be a partial or complete loss. Out of this, the VCs are trying to create a fund that earns 15-20%+ over 7-10 years and pay themselves well along the way.

If you think about it, that means VCs value investments in a completely different way from most investors. While you or I might hope that an asset class won’t underperform for more than 10 years before coming back (or a stock 2-3 years), they are prepared to outright lose 60% of their money! So they don’t value an investment on the probability that it will return 10% per year; instead they value it as if it will change the world.

Back to AirBnB above, just a few days ago I read this interview 18 months ago where the founders talk about how they started it in October 2007 to pay rent for a month. Now there’s nothing wrong with coming out of nowhere and earning a $1B valuation in 4 years (never mind all the companies that took 50+ years to earn it). But one of the interesting things is that the interview shows their revenue at the time came from a 10% cut of booking fees. Let’s take that $1.3B valuation and assume the investors want it to be 10X the company’s earnings in 3 years to get their value (which means that an IPO at 15X P/E at that time would give them a 50% return, with a valuation of $2B). That means that in 3 years it will have to be selling $1.3B of bookings a year. Given that it’s supposed to be cheaper than hotels, that might be 14.4m nights sold at $90/night average or 26m nights sold at $50/night. The FT article above mentioned the site has sold 2m nights in the first 4 years. Assuming rapid growth, that might be 1m/year at this point. The recent valuation appears to be based on something like 14-26x growth in 3 years.

It’s certainly not impossible for the company to grow that fast, but it’s a hint that most investments of this type do not work out. Now the VCs want to earn their big return by the time of the IPO and then get out, but you have to wonder if the principle of ever-rising valuations carries a similar breakdown of returns into the post-IPO market. Would you buy 10 IPO stocks in the hope that one will make the portfolio? Do even the brightest stars have to exceed all expectations or just live up to the promise to do that? I have a feeling that many IPO buyers may get a worse risk profile than the VCs unless they learn to think the same way. And even then, they might end up like the 80%+ of VCs who don’t create significant value. I’ll just keep using IPOs as entertainment šŸ™‚


Step Away From the CPP!

July 25, 2011 1 comment

Recently there have been many suggestions that the CPP should be increased, some going as far as saying it should be doubled to provide a comfortable retirement for everyone without requiring any thinking along the way. This was the deciding factor for my vote in the federal election because I don’t think increasing the CPP is a good idea. The immediate effect would have two parts: higher taxes on workers and employers (everyone earns less now, and some jobs may evaporate), and higher payments to those who are retired now or in the near future. This makes it an excellent idea if you’re 60+, but not so hot if you’re in you’re 20s.

In fact a 25-year old would be paying more (or be employed less) for 40 years, after which they may have 30-40 years of retirement using today’s numbers with a bit more longevity. Which means they only see a benefit if the CPP can last without any form of deterioration for the next 60-70 years. And that in turn is only likely if today’s young people get busy making another baby boom.

I don’t think the wheels are coming off just yet. A recent Fraser Institute report shows that the CPP is still doing well, but as it continues natural growth with the current parameters its investment performance is likely to decline. This is another reason not to increase it since more investment capital would just lower returns. Put in 100% more and you get 80% back.

Now I don’t think the alternative PRPPs are much better, because you end up with the same problem on a different scale. Instead of having everyone depending on one mediocre fund, you have people depending on a large number of funds. Some will do better and some will do worse, meaning there will be winners and losers. If all PRPPs just stick to index funds, that will have the effect of smoothing out and lowering index returns for everyone. Increasing investment at a national level will have to face declining returns.

There is no simple fix now because the current ideal has been sold in a way that most people will not end up getting. We’re still using a retirement age that was set back when it was a mark of amazing longevity, but now the average person expects to be retired for 20+ years and in another 40 years that could extend to a much longer time. This can only be supported if you’ve been planning ahead for a very long time or if you’re in an extremely favorable investment environment. And many people seem to be too stuck in the defined benefit mindset to prepare.

If we can straighten out retirement planning so that everyone contributes adequately to prepare in advance (which is harder when you’re supporting many more who didn’t), or if we can straighten out our investment and business priorities so that we’re putting enough into science, technology, and productivity to produce the housing, food, energy, and exotic cruises we all need while everyone works 20% less over their lifetime, we might be able to give everyone a chance to live the dream. Until we recognize where our choices are leading us I won’t support any short-term cover-ups and I’ll stick to my very non-traditional financial/retirement plan which isn’t built on having others support me.

Where Will Markets Go Next? Follow the Fund Flows

July 21, 2011 Leave a comment

I don’t know if there’s ever a time when it’s obvious where the market is going in the next few years, but this time seems particularly difficult. The current situation has stocks that are slightly or moderately above fair value, and bonds (both short and medium-term) with very low yields. At this point you would expect there would be pressure for interest rates to rise and for stocks to possibly start drifting lower. And if you read the news you could switch your position every day. Are we headed for a crash, or will markets keep defying gravity for a while longer? Is cash a good stabilizer or a lost opportunity?

The key, as always, will be fund flows. Investment markets don’t gently move to the ideal price and then stay there. Instead they swing back and forth between extremes, driven by investors who are chasing the hot performers and bailing out on anything that’s falling. The best decision is the one that gets you ahead of other investors. In thinking through the current situation, I came up with 3 pressures that are affecting today’s market:

  • Many investors, fearing risk, have switched to the safest investments they can to avoid losing capital. This has driven up bond prices.
  • Others who need income have abandoned low yielding bonds to seek out alternatives. This has driven up stock prices (and seems contradictory to the first point).
  • Many investors are likely still afraid to move and sitting on cash, waiting to deploy it. Some have good reasons (waiting for prices to fall) while many likely have bad reasons (waiting for prices to advance further). Others aren’t consciously sitting on cash but will be sucked in once we haveĀ  “no-lose stock market”. This could lead to stock price rises in the future.

And there are 3 important factors that will play out in the future:

  • Interest rates will rise, in different ways at different times. This will hurt bond prices but lead to higher demand.
  • Investor confidence could go either way, since it is sensitive to the smallest unpredictable things. It doesn’t seem to be close to previous peaks yet and has been moving up, so the trend could continue.
  • Fundamentals are likely to improve, but may get worse. These operate at the individual level (employment leads to investment) and the collective level (don’t expect heavy government spending). Despite the bad news, there is growing demand in emerging economies that may drag along the rest of the world (but who knows what’s really happening in China?). This may drive inflation in slower-growing economies.

Of these factors, my expectation for the most likely scenario is that interest rates rising are a near certainty, investor confidence tends to follow the trend but could reverse any time, and fundamentals will move very slowly and may only have an impact over 10-20 years. So the next few years could go something like this:

  • Central bank rates rise. This has an impact on medium-term bonds, but every time their yield goes up, some investors who need safe income come back to bonds and contain the price increase (in Canada, 5-10yr yields have apparently fallen over the last year). Medium-term bond yields could stay low for some time but might rise fairly quickly once the short-term pressures run out.
  • Investor confidence grows as they get bored with macroeconomic drama, leading scared investors to move out of bonds and into more risky investments (the bond market is huge so it probably won’t crash because of this). This could easily push stocks and other alternative investments higher.
  • Growing confidence moves cash into investments, more on the risky side than in fixed-income.
  • Stabilizing fundamentals could lead to rises in exports from China & co, giving them more cash to invest in US Treasuries, buy up companies in developed countries, and inflate their own economies.

Despite all the negative news, there is a story that supports some further growth both in safer and riskier investments. Will this happen, or will the curse of the forecaster strike and make me 5 years early? Let’s hope bond yields start seriously rising in 18 months, with the stock market peaking a year later and allowing me to move some profits to safety and higher yields!

Conclusion: despite the drama in the news, there are a lot of opposing forces being ignored and it’s not time for any dramatic moves.

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