As Angel Investors Pull Back, Valuations Take a Hit

I'm concerned with the current state of valuations - I enjoy giving investments to companies on the order of five figures or so each with the hope that they make something meaningfully impactful. I don't necessarily look for them to become moonshot successful; a win can be much smaller than that. Developing incrementally impressive technology that effects change is also a win.

But valuations are so frothy right now that it's difficult to tell the strong companies from the ones that won't survive "when the tide goes out." It all seems very clear in hindsight, but it's hard to know right now, even moreso than usual. This is always very difficult, but the market for ideas has become somewhat "congested."

There has been a flood of folks entering the "startup game" who seem to be planning for their IPO before they've even gotten a product off the ground. Again, anecdotally, I'm observing a noticeable increase in fraud among founders who are trying to raise money unscrupulously, especially with novice investors.

I don't like to use the word bubble because I think it's lazy analysis, but I do strongly believe valuations are in the beginning of a market correction. At the very least, I think there will be a higher bar for invested money to indicate a legitimate valuation instead of a loan.

I do think that there will still be plenty of capital ready to be given to companies, investors are just going to be more selective (read: cautious) about it, which may very well change the growth and success potential of certain more dubious business models in the valley.

It seems like a big deal until you realize there is a huge variance in prices and that 2012 isn't very long ago. The biggest and most successful ones seem to be doing just fine.

In the United States, ~32,000 people die annually in car accidents. In New York, ~1200 people die annually in car accidents. I live in New York. Which statistic do I pay attention to? Does it influence my analysis of total vehicular accidents that New York has a much higher population density than most of the country? Am I more likely to die in New York or somewhere else?

What is the startup building? What is the existing market the product? What experience and domain knowledge do the founders have? How far along are they? Who are their actual and potential customers?

That's the first five minutes of a due diligence conversation. If it were so easy to divide potential winners from virtually certain losers, people would hedge so well they would lose almost nothing and most angel investors would become rich. The reality is very different.

It probably will as things start to slow down.

During the growth phase of the business cycle, many companies do well. Even some with poor fundamentals that shouldn't. This is the danger of stimulus - it promotes an inefficient and wasteful allocation of resources. But it makes investing easier as a larger pool of companies are succeeding and finding exits for their founders and investors through IPOs and acquisitions, which are both very closely correlated with the health of the stock market.

During the contraction phase, the companies with poor fundamentals are exposed. Ok, no loss there, they were struggling and nobody really believed in their potential anyways. But contractions can also bring down good, solid companies who were just caught unaware and were not holding enough liquid assets to pay their employees and the interest on their debts. Some non-negligible percentage will not make it through a rocky period while liquidity dries up and relatively cheap funding/investing slows down.

I think it's smart to not read too much into the stock market as it can be distracting and noisy, but I think its trajectory and what it indicates about the phase and timing of the next business peak/trough cycle is extremely important and should not be discounted.

It's the same as to compare someone on absolute salary of $100k in Silicon Valley vs $50k in Estonia, forgetting that the latter can provide a luxurious lifestyle with tons of money to spend, while former can mean being barely break-even.