Back in 2010, a headline caught me by surprise: Amyris, a Bay Area startup that used bioengineered “magic yeast” to turn sugar into diesel fuel, had raised $133M in a Series D financing. At first my head rang with the sounds of imaginary corks popping in San Francisco — a successful startup was raking in the cash!
But as my rational brain caught up with the reptilian, something didn’t fit. Amyris had raised $41M just nine months earlier. It operated in what is effectively a commodity business, with entrenched incumbents that have deep pockets. With a funding total now approaching $300M, I assumed (but couldn’t be sure) that they had a post-money valuation north of $500M, with no earnings. And now that I think about it, I’ve seen a lot of monster rounds like this. What on earth? Are we overshooting?
Raise ’til you’re out of options
Since 2010, Pitchbook has tracked 479 exits for venture-backed companies in the Boston-Cambridge venture ecosystem (being Boston-based I focus on the data for the ecosystem here, but other cities are broadly similar). In that time, there have been about 80 exits a year, with an average exit value of $55M. Because a few huge exits tend to lift the average, it’s probably safe to assume that the median was lower, perhaps significantly lower.
Most of those exits were M&A — acquisitions of small private companies by much larger companies. The large-cap companies of the world often buy smaller companies in the $50M range — to acquire technologies, new customers, new geographies, or for any number of other strategic reasons. M&A activity at much higher valuations is much less common. The highest-value exits are more likely to be IPOs, which have been rare recently.
So, once a venture-backed company has raised over $50M in equity, and its private valuation is in the $100–200M range, exit options start to disappear quickly. The venture backers are looking for substantial returns — they didn’t invest $50M just to get their liquidation preference back. So they will (and logically must) push the company to “swing for the fences” and achieve high growth that can justify a unicorn valuation. But the numbers tell us that exits at that level are few and far between.
This is “overshoot” — a private company that has raised lots of money at a valuation higher than its available exit options. Once you’ve overshot, bad things happen. Investors and entrepreneurs both have an incentive to chase huge opportunities that may or may not exist, in order to justify the inflated valuation. And they are inclined to pour in more money hoping for some massive jump in earnings rather than correct the original overshoot.
All the cool kids are doing it!
So how often does overshoot occur? Well, the 68 “late-stage VC” rounds in the first half of 2016 in Boston came at an average post-money valuation of roughly $100M — already double the average exit (and much higher than the median exit).
So on average, current late-stage VC investments will be losers. Boston averages 80 exits a year at $55M, but is on track to make almost 140 equity investment this year with post-money valuations of $100M. Many of those investors will feel lucky just to get their liquidation preference back. All will push those companies to get to unicorn valuations and IPO (which as we’ve seen lately, doesn’t happen).
So, What Does It All Mean?
So are we all doomed? No. Every company is different, and exits do happen at $500M+. Some companies clearly earn that valuation on the fundamentals. But the case of Amyris is instructive. They were able to ride the biofuels wave and the public’s fascination with the technology to a successful IPO in 2010, with a market cap that briefly touched $1.5B. But financial realities soon caught up with the company. The unit economics on its fuels business never worked, and the successful business lines — cosmetic and fragrance ingredients — were much too small to support a $1B+ valuation, so the stock fell back below $100M. Once the markets look beyond the hype — and they always do eventually — the valuation fell back to the intrinsic value of the business. In the case of Amyris, the overshoot misallocated $300M chasing a biofuels mirage, when a smaller amount of capital could have built a successful (if smaller) ingredients business and made money for everyone.
And this is the key lesson. Venture investors should read their Graham and Dodd just like public equity investors. Valuations fluctuate around the intrinsic value of a company. Sometimes Mr. Market is crazy and gives $1.5B valuations based on hype; often he doesn’t. So investors should pay attention to value creation and exits that are realistically available. But in general, VCs today are acting like start-ups are from Lake Woebegone: all the kids are above average. They aren’t.