Market Overview

Is Silicon Valley In Crisis?

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Is Silicon Valley In Crisis?

Heard on Friday from a friend running a startup: "Well, there goes my valuation. I'm in big trouble." Silicon Valley's start-up economy depends on a rising stock market.

Rising stock market prices –> creates cash-out opportunities (IPOs) –> establishes valuations for private companies –> attracts capital

Falling stock market prices –> eliminates IPO cash outs –> cuts valuations –> reduces available capital and liquidity

The Big Dominoes Just Fell

Silicon Valley's economy rests on the stock market more than any other US city outside of New York. Investors pour in billions of dollars with the expectation that the startups will have some kind of liquidity event:

Go public – Facebook Inc (NASDAQ: FB) $100B+

Get bought – Instagram $1B

Either way, investors provide capital as long as the music is going and the risk/rewards make sense.

Everything hinges on valuation. Valuation creates investment activity. High valuations attract the capital and a lot of follow-on companies. Uber was followed by Lyft, for example.

Valuation justifies the capital raised. Silicon Valley is ultimately selling dreams, as valuation often diverges from fundamentals. For example, Tesla Motors Inc (NASDAQ: TSLA) was getting a massive price/earnings ratio (P/E) based on the potential sales and not on actual sales growth. Valuation helps to calm nervous investors.

It also rewards prior investors. If Acme Fund invested in the first round, it wants to see the company's value double in the second round, otherwise the risk/reward is thrown off. Square (SQ) IPO'ed at a $4.2B valuation. Prior to that, in 2014, it had raised money at a $6B valuation. That's a big haircut for the last investors.

At the heart of valuation is the stock market. Small companies always have a choice: get bought by a bigger company or IPO. In either case, investors want some form of exit (the liquidity event). Small companies can use recent IPOs to set the bar in their merger discussions. They might say, "We can get 20x if we IPO, so you should pay 40x assuming the premium you would pay to take us private after we go public."

As soon as Facebook went public, tons of other social media start-ups applied the same market-cap-to-users ratio.

When The Music Stops

Over the past two months, high tech stocks have been getting slaughtered. LinkedIn Corp (NYSE: LNKD) is down 45% since the start of the year, for example. If it hoped to be acquired by a public company, falling stock prices limit its ability to do stock-based buyouts. Public company valuations are crashing. Similarly, there are no IPOs.

So Investors are faced with a basic problem: the hoped-for liquidity event will be much less rewarding if it comes. For public company acquisitions, falling stock prices limit their ability to do stock-based buyouts. Either way, the easy money is leaving, and it creates a vicious cycle. As valuations get cut, prior investors get burned, and that means even less money flows into Silicon Valley.

Applying The Math

I have a friend who co-founded a billion dollar public company and left to do another start-up. About a year ago he raised $10M on a pre-money valuation of $20M. That covers 18 months of operations at projected cash burn rates, which means he has to start raising another round of capital later this year.

He has to get a $60M pre-money valuation in his next round in order for his initial investors to be happy; a 2x return. That's the way the game is played. But the recent wipeout in tech stocks, coupled with the lack of IPOs, means that a $50M valuation will be tough to get.

If he is nervous, imagine the situation at other companies that need the money now.

The Losers: Real Estate

The big losers here are those in real estate.

The local real estate economy is driven by the stock market. Down payments of $300K are needed and that comes from either stock options or RSUs (stock that gets handed out over time). The options are now largely worthless. Linkedin, for example, has fallen to 3-year lows. Many companies offer employees RSUs, where the loss is a milder 20%+ (depending on the company).

This means that down payments just got whacked by at least 20%.

Silicon Valley real estate is about to take a big step down again, and that's before any employment issues crop up. Many Silicon Valley companies are laying off employees, like HP Inc (NYSE: HPQ) and Yahoo! Inc. (NASDAQ: YHOO). But the real wave of layoffs is not here yet. At the same time, nobody is hiring either.

The Winners: Big Companies

Small companies and startups just went on sale.

If you're Facebook or Cisco Systems, Inc. (NASDAQ: CSCO), you can buy a lot more companies with the same budget. And those small companies are now running out of alternatives to get the cash to stay afloat.

Timeline Of Events

It will take about six months for the pain to materialize in the macroeconomy.

Silicon Valley private industry is ~4% of the US GDP. If spending pulls back 10%, that's a 0.4% hit to the US GDP.

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