Middle East Ventures

A recent article in the NYT (read it here) gives the impression that Silicon Valley is “awash in dollars, again” and that valuations of companies are off the charts. Like most media coverage of the valley there is some truth to this, but it certainly is not as blown out of proportion as the article conveys:

Internet companies with funny names, little revenue and few customers are commanding high prices. And investors, having seemingly forgotten the pain of the first dot-com bust, are displaying symptoms of the disorder known as irrational exuberance.

But, yes there are some astronomical valuations being thrown around. When it comes to valuation investors and entrepreneurs both know its more art than science; and investment bankers are more than eager to help the investors and entrepreneurs reach “the right valuation” (after all, that’s how they get paid). Having said that there are few signs of the “irrational exuberance” from the side of the bankers. They are all too familiar with the collapse of the first bubble and what that meant for their industry.

On the venture capital/entrepreneurial side, however, the matter is different. Entrepreneurs are now demanding sky-high valuations for nascent companies, if not ideas. Entrepreneurs are now often blinded by the valuations of YouTube, Facebook, and other Web 2.0 companies and demand similar valuations. VCs, then, are forced to educate entrepreneurs and temper expectations. While Ning, as the NYT article points out, is being valued at $200mm, some if not most of that valuation is being driven by the previous success of Marc Andreesen (of Netscape and Opsware fame). In the Valley, success begets success and VCs are more likely to invest with a proven entrepreneur than take a risk with someone who’s unproven. VCs are in a difficult position as they are inevitably confronted with the informing entrepreneurs that they are not Marc Andreesen – not an easy task.

Part of the challenge is that there is now an abundance of capital chasing technology deals. As VentureOne and Ernst & Young have pointed out (read it here), VCs invested $7.1bn in 3Q07. Tech investing used to be the domain of seasoned VCs. It is now open to traditional LBO and hedge funds who are now also competing with Sand Hill Road. And unlike VC firms, LBO and hedge funds offer cheaper money to entrepreneurs, meaning higher valuations. As such, when VCs think they’ve spotted a promising company, bidding wars are not uncommon.

At the end of the day, VCs know that there are very few companies that will be able to promise the astronomical returns they seek, so when they spot a company that appears to be a winner, valuations will naturally increase.

The NYT article paints a nearly ominous picture – foreboding of the crash – but what the article fails to point out is that unlike last time, these companies are not going public. Public investors are well aware of the consequences in buying shares of companies that had no revenues. We won’t be seeing an IPO of Twitter anytime soon. But what VCs know, and what the article doesn’t mention, is that companies which have a large and growing number of sticky users, often turn huge profits for VCs (think Hotmail, Skype) and often become hugely successful businesses (which is what Facebook is being primed for and which is why companies like Meebo and Twitter were so sought after for investment).