IDGVI News: Media Coverage 2014

Tech valuations: Ill-fated inflation?

Asian Venture Capital Journal – December 10, 2014

by Andrew Woodman

As valuations in the tech space continue to soar, comparisons are inevitably drawn with the dotcom bubble era. Asia can point to favorable fundamentals, but it remains to be seen whether the exuberance is justified.

In September, David Zhang, co-founder of Matrix Partners China wrote open letter to his portfolio companies, advising the start-ups to raise capital while they still can and for those who had already received funding to use it sparingly. The message was clear: the good times - sooner rather than later - would come to an end. He added that investments and valuations offered to many of China's start-ups are not only exorbitant but unsustainable.

In his letter Zhang also quoted Bill Gurley, a partner at Benchmark, who days earlier drew comparisons between the environment in Silicon Valley today and the dotcom boom of 1999. In turn, citing Warren Buffet, Gurley had told the Wall Street Journal. "No one's fearful, everyone's greedy, and it will eventually end."

Issues over valuations are not unique to the US, nor China for that matter, where events such as Alibaba Group's $25 billion IPO is said to have helped boost late-stage investment in a string of other companies. File-sharing service Xunlei and group-buying site, for example, have each received rounds of $300 million or more in past 12 months. The former has already gone public; the latter wants to follow suit.

India too has seen some sizeable late-stage rounds, notably Flipkart, which raised $1 billion - the second-largest VC round globally so far this year. Many industry participants agree that Asia, and the rest of the world, is in the midst of a tech bubble, though not all agree on the likely denouement. Comparisons with the dotcom era are tempting, but many maintain they are also fundamentally erroneous.

"I think there is a bit of a bubble, but people always compare today with 1999 or 2000," Wei Zhou, managing partner at Kleiner Perkins Caufield & Byers (KPCB), told the AVCJ Forum in Hong Kong in November. "However, the fundamentals are totally different."

Money, money, money

Taking a broader look at investment activity, AVCJ Research data show more capital is entering Asia's VC space than ever before. So far this year, $14.2 billion has gone into 1,600 deals, $5.7 billion more than 2013 although there are about 200 fewer transactions. Early-stage deals - which are more narrowly defined - are also at record highs. A total of $4.8 billion has been committed region-wide, up from $3.8 billion in 2013. As with the VC space, the number of deals has fallen, from 850 to 730.

The other trend is that larger investment rounds have featured more prominently. Already this year there have been 12 early-stage investments that have surpassed $50 million mark, more than the previous two years combined. But it is not just that VCs are investing more at a later stage; earlier rounds are getting bigger as well.

According to Preqin, in China the average Series C round totals $54 million this year, compared to $26 million in 2013. Meanwhile, the Series D round average is $84 million, up from $76 million. This is a global trend, but one of which Asia is very much a part. Of the 10 largest VC rounds that have taken place globally this year, six were in Asia: India's Flipkart; China's Beijingmate, Xunlei, and Youxinpai; and Australia's Campaign Monitor.

Scott Kupor, a partner and COO at Andreessen Horowitz, describes a fundamental shift in the venture capital ecosystem in the US where start-up are raising a lot more capital via private markets than they did 15 years ago. He notes that 90% of the largest venture capital rounds in history have happened in the last five years.

"The bubble analogy does not do justice to the market we are in right now - that oversimplifies things because something is changing and something is happening in the market from a valuation perspective," says Kupor. "The competitive opportunity and the market opportunity are now so great that companies are raising more capital earlier on in their life-cycle than they were to take advantage of these opportunities."

In the US, Kupor points to a number of key differences between the venture-backed companies of 2013 and those of 1999. First, the median company age at IPO has increased from four years to nine. Second, median sales at the time of IPO have also increased from $12 million to $106 million today. Third, less money is being raised through IPOs. The proceeds of US tech IPOs came to $17 billion in 2013, less than a third of the $55 billion raised in 1999.

This shift in value accretion among start-ups from the public markets to the private markets is also visible in Asia. Part of the background to this is that market opportunity for internet-based businesses that make up a large proportion of VC activity has vastly improved. David Yuan, a partner and managing director with Redpoint Venture, points out that the migration of internet users from desktop to mobile, and greater mobile adoption in emerging economies are just two factors that have dramatically changed the landscape.

"All of a sudden your addressable market has increased from tens of millions to billions - the market is so much bigger," he says. "Another trend is that in China, and the rest of Asia, we are seeing a lot of online-to-offline (O2O) models that are disrupting a very large tradition of offline businesses in a very significant way.

KPCB's Zhou adds that users have also changed. Whereas the first generation failed to understand the value of the internet and hence was less willing to pay, younger mobile-enabled users are much more likely to pay for quality services and content. Advances in technology also mean it costs less to start a business - this ever-growing addressable global market has become far more accessible with fewer resources.

On the one hand this has opened the door to angel investors writing small checks. However, the flipside is that these start-ups also have the potential to scale up quickly, especially in a competitive market. The result is that demand for more capital soars.

"These funded companies can grow very fast," says Juxin Foo, a partner with GGV Capital. "Xiaomi is a good example. It is less than five years old but it's selling more than 60 million smart phones per year. It's growing fast and we have to take that into account. I think the valuation is a reflection of mobile disruption."

Xiaomi received seed funding from Morningside Technologies and Qiming Venture Partners in 2009 and launched the following year. A Series A round of $41 million came in late 2010 and a Series B of $92 million the following year. DST Advisors led a $216 million Series D in 2012 that valued Xiaomi at $4 billion. One year and one round later, the company was worth $10 billion and is said to be in talks over further funding that would value the business at $50 billion.

To put that in context, Lenovo Group has a market capitalization of $10 billion, while Japanese electronics giant Sony Corp. is valued at around $20 billion.

Are such eye-watering valuations for relatively young companies justified? One perspective is that expectations among Chinese entrepreneurs are higher, based on what they see happening elsewhere in the marekt. However, the quality of founder is also changing with a new generation of entrepreneurs spinning out of successful internet companies.

Xiaomi is the stand-out example. The company's co-founder is Lei Jun, a member of the group that set up Chinese software developer Kingsoft Corporation in the 1990s. He he has helped develop a string of start-ups, including social networking site YY (now listed in the US), mobile browser UCWeb (sold to Alibaba), and Xiaomi. Equally, Xing Wang, CEO and co-founder of Meituan, cut his teeth with VC-backed social networking sites Xiaonei and Fanfou.

Interesting bedfellows

But large pools of capital also gravitate towards sectors that have demonstrated traction. Nowhere is this more evident than in India's e-commerce space, which attracts the lion's share of VC investment entering the country.

"Valuations seem to be rising fastest in e-commerce, where companies are being valued on revenue growth alone on the assumption margins and unit economics will rise," explains Manik Arora, a founder and managing director with IDG Ventures India. "It remains to be seen the speed at which these margins rise in India."

An interesting characteristic of these large rounds is they not just populated by traditional VC investors. Indeed, such is the size of some of these investments that VCs are raising "opportunity funds" - vehicles dedicated to follow-on investments in existing portfolio companies that have grown beyond the size remit of a standard VC fund - in order to participate, or simply sitting on the sidelines.

Flipkart's recent $1 billion round included the late-stage investors like DST Advisors investing alongside return backers Accel Partners and Tiger Global. Meanwhile, when rival online retailer Snapdeal raised $100 million in May at a princely valuation, the consortium featured Temasek Holdings and Hong Kong-based hedge funds Myriad Asset Management and Tybourne Capital Management also participating.

"At one level the venture market lacks depth and the private equity investors in India do not have a very evolved view of tech investing so that space is being occupied by folks who do public and private investing," says Sanjeev Aggarawal, co-founder of Helion Venture Partners. "Some of them see these deals as pre-IPO and some are trying to get additional alpha in their portfolio so they want to do some private."

Strategic investors also increasingly active in larger rounds, with SoftBank the prime example. The Japanese telecom giant - which is sitting on a paper gain worth billions thanks to an early investment in Alibaba - committed $627 million to Snapdeal in October and has said it will remain a prolific investor in Asian start-ups. Around the same time it pumped $210 million into Indian online taxi-booking platform Ola.

The Chinese internet giants - led by Baidu, Alibaba and Tencent Holdings - are also aggressively diversifying their businesses, buying stakes in start-ups or in some cases acquiring businesses outright. It all contributes to the driving up of real or expected valuations.

"All those guys are very paranoid. They see the stories about Yahoo and Sina and they know if they don't move forward, they go backward," says J.P. Gan, a managing partner at Qiminig. "That is why they raise so much money and they don't hesitate in pulling the trigger."

Unnecessary risks

The problem is that, with so much capital looking for deals, are investors taking time to separate the wheat from the chaff? Clearly not. While DST might say Flipkart warrants a lofty valuation because it has emerged as a leader within its market, much of the wave of money entering seed rounds - and therefore helping to pump up valuations further down the chain - is being invested indiscriminately.

"I think with the surging inflow in dollars and capital, there are a couple of negative effects that we have to cognizant of," says Redpoint's Yuan. "Companies are raising more money, arguably more than they need, and that is encouraging negative behavior in terms of getting the right product and getting the right marketing strategy."

In short, companies that should not be funded are getting funded. Yuan adds that this is particularly the case in markets like China that see a proliferation of copycats. If one business model gains traction and then suddenly dozens of others are getting funded around it, it creates a level of competition that might not be justified by the commercial opportunity. And so costs go up.

Should the VC industry be concerned? The adage that has been floated time and again by industry participants is that a rising tide lifts all boats. Matrix's Zhang also pointed out in his letter that a surplus of capital will inevitably leads to indiscipline. This is often manifested in due diligence being neglected as investors race to deploy capital.

While the market is very different to what it was 15 years ago, Andreessen Horowitz's Kupor stresses that plenty can still go wrong and investors should remain vigilant - there are still pockets of exuberance in market and one jolt might cause cracks to appear.

"There is still a significant amount of macro shock risk to the global market that certainly could change things," warns Kupor. "There are macro trends that - despite all the wonderful activity we might see in terms of new company formation on the tech side - could cause valuations to change significantly in a short period of time."