Reality Check: For Most Young Startups, Billions Are Elusive

There is another term for Sugar Daddies. In Wall Street parlance they are referred to as 'strategic buyers,' because they are allegedly so far-sighted that they will pay exceptional premiums for startups with paltry earnings due to their supposed ability to see into the future and discern potential where others sense only uncertainty.

This is, of course, simply a diplomatic way of the middlemen in pin stripes to compliment someone for giving them and theirs an undeserved payday and making the buyers feel good about it.  

As mobility, social and related technological developments become less expensive to generate and more entrepreneurs are doing it, there seems to be a growing sense, counter to normal economic projecting, that if those guys can get bought out for a huge valuation, anyone else can do so, too. And there does seem to be a lot of funny money floating around as Google, Apple, Ali Baba, Facebook and others attempt to outwit each other by making eye-popping purchases that align their prospects with the heavens.

But as the following article explains, the chances of your average startup realizing that sort of payday is, by far, the exception rather than the rule. The truth is that valuations have changed very little in the past decade - and they tend to be on the petite side, especially for the newest and smallest. The implication is that you might, as the saying goes, get lucky, but then you might also hit the lottery. JL

Angus Loten, Emily Chasan and Russ Garland report in the Wall Street Journal:

"The cost of getting off the ground is getting lower, but that also means there is simply less value there,"

Young companies thinking they might be worth billions may need a reality check.

Despite the hubbub over select startups such as WhatsApp, the mobile-messaging app bought by Facebook Inc. FB in Your Value Your Change Short position for $19 billion, first-round valuations for U.S. startups fell last year, data show, even as later-round valuations surpassed levels of the dot-com era.

Seed-round funding valuations—set as a business prepares to launch, or soon after—dropped nearly 30% in 2013 to nearly $2 million, from $2.7 million in 2012, and less than half of a $4.8 million high set in 2000, according to Dow Jones VentureSource. Likewise, first-round funding valuations fell to $5 million, down 28% from $7 million in 2012 and off 58% from 2000's $12 million.

Slightly more established startups seem to be better off: Private companies that were up and running and which got third- or later-stage venture-capital financing rounds last year saw a median valuation of $103 million, up 61% from $64 million in 2012 and surpassing a previous high of $89 million in 2000, according to VentureSource.

There were 3,480 equity-financings in 2013 into U.S. venture-backed companies, totaling $33.08 billion, according to VentureSource. The valuations are "pre-money," meaning they are set just before receiving a venture-capital investment.

Part of the problem, venture capitalists say, is that it is hard to come up with a value for small companies that don't have revenue or profits yet. "Valuing early-stage companies is an art, overlaid with science, and a lot of supply and demand," said Nick Beim, a partner at venture-capital firm Venrock Associates in New York.

Overall, it is only a small group of startups, such as messaging service Snapchat Inc., that can gain quick traction with users, and thus draw intense investor interest—despite the risk of failure. "It's just rare that companies capture the lightning in the bottle that causes them to grow so quickly," said Jeremy Levine, a partner at Bessemer Venture Partners whose portfolio includes scrapbooking website Pinterest Inc.

So unless they have a hot new technology, investors are hesitant to give very small firms big valuations. Initial public offerings of companies valued under $50 million represented 80% of the IPO market in the 1990s, but are less than 20% of the market today, according to David Weild, chairman of investment bank Weild & Co. and former vice chairman of the Nasdaq Stock Market.

According to Mike Carter, CEO of BizEquity, a Wayne, Pa., based online small-business valuations firm, the value of small private firms align more closely with growth in gross domestic product, rather than the ups and downs of the stock market. That's because they are largely set on revenue and earnings, he adds.

In its analysis of more than 950,000 debt or equity-backed ventures with less than $50 million in revenue, BizEquity found that average inflation-adjusted valuation was $1.8 million in 2013, up only slightly from $1.77 million in 2012, and unchanged from 2001. Some of the businesses in its data pool are in wholesale trade, transportation and warehousing, and public administration—industries that aren't the type a venture-capital investor would typically put money into.

Marianne Hudson, executive director of the Angel Capital Association, a trade group of early-stage investors, says it is much easier to launch a technology startup today, thanks to the Internet, cloud-based software and cheaper hardware: "The cost of getting off the ground is getting lower, but that also means there is simply less value there," she said.

At the same time, she added, early-stage investors are becoming more sophisticated and are better at valuing a startup now than they were a decade ago. That's likely kept valuations for nascent firms from rising, and brought values more in line with the market, she added.

For some entrepreneurs, the soaring valuations of later-stage companies are an incentive to stay closely held as long as possible. Matt Voska, a co-founder of Flytenow Inc., a flight-sharing service based in Boston, said he is holding out on selling equity in the business until it is more established. "We're bootstrapping for as long as we can, because the later you seek funds the better deal you're going to get," he said.

"My sense is that valuations of fairly young companies haven't budged in the past 10 years," said John Huston, manager of an Ohio-based group of wealthy individuals, or angels, who invest in tech startups. "We give them money today and hope that they will be more valuable in the years ahead. And that's risky. It's likely that many of these companies will be worth zero," he said.

Supply and demand are also factors, he said, citing an explosion over the past decade in the number of accelerators and incubators, all fostering the creation of new businesses. As a result, he said, entrepreneurs are encountering far more competition for early-stage funding, as more startups hit the market. "I've never seen so many entrepreneurs seeking funding," he said, adding that investors often have a set number of deals they can choose every year: "So we pick the very best ones we can find at any given time," he said.