In the current crazy spin cycle of Wall Street, it's easy to stop asking questions about underlying company value and simply hit the panic button. After all, when your finance.yahoo.com page tells you that your stock portfolio tanked 17 percent in a week, few are able to shift gears and think about the more enduring qualities that make individual companies succeed or fail. Yet it's precisely when we hear cries of "the sky is falling!" that level-headed people calmly assess the situation and look for the opportunities created in the wake of crisis and government intervention in the markets.
As someone who has worked for five software start-ups over the past 15 years, I have observed that while company valuations can wildly fluctuate with market moods, companies that launch innovative products and cultivate enduring customer relationships ultimately establish value.
What hasn't changed in the past two months of turmoil are certain fundamentals. More people are using the Internet more frequently. Bandwidth is expanding. The nexus between the mobile world and the Internet is strengthening, led by new devices coming to market. Video games such as Madden NFL '09 continue to wow users in terms of graphics and new features. In short, the digital world continues to evolve with more richly-featured products that can be used on a variety of networks. The long-term trends for software and mobile industries look good.
Most start-up companies at this moment are living off cash raised from early rounds of fundraising and are calculating whether they will need future financial injections or get to "cash positive" before they need to tap their venture capital investors and angels for more money. With or without lectures from Silicon Valley, we all feel the need to conserve cash, while we continue to hire smart people and make the right decisions in terms of product development.
How do venture capitalists look at the current turbulent market? There's no initial public offering market this year and probably through 2009, so "exits" will be achieved through acquisition or merger. In the absence of public stock offerings, it's easy for VCs to take a conservative stance and say: "Well, let's look for companies with growing revenue who are nearing sustained profitability." In short, their telescopes shift toward late-stage enterprises who have been selling products, gaining customers, and learning how to manage cash flow and invest in R&D to maintain innovation. From this perspective, it's always easy to justify making the "safe bet."
The paradox is that it's the late-stage companies which are nearing profitability that need VCs the least, unless they are planning substantial growth, either internally or through acquisition. There's definitely going to be "roll-up" activity in the tech sector, as healthy mature companies grow through acquisition. Late-stage performers who have managed their cash wisely will be able to dictate relatively favorable economic terms from potential investors.
By contrast, the "long bet" companies are developing or have just launched new products into the marketplace. These angel or A-round financed companies are still in the early phase of winning customers and establishing their competitive positions. In short, the valuation of early stage companies still centers on "the vision" as much as any other factor.
One might argue that VC money, with its high return-to-risk equation, is best placed on the long-bet start-ups, as these early stage companies will drive innovation, create dazzling new products that consumers love, and become market leaders. Over the next few months, we will witness a shakeout in the start-up world, where companies with little market traction and dwindling cash will have difficulty finding new investment. At the same time, well-managed companies with customer-focus will become more attractive to VCs who buy their product vision.
In a time when fear is driving global financial markets, public companies and commodities are experiencing record levels of volatility, and their dollar prices are determined less by value and more by market psychology. Under such conditions, long-term investors might seek the relative calm of early-stage private companies, even though the inherent risks of venture capital remain.