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Summary:

Paul Graham of Y Combinator has warned startups they have to be more cautious in the wake of the lackluster Facebook IPO. But did Facebook really pop a venture-financing bubble, or did it just allow some of the steam to escape from an overheated market?

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When Facebook’s initial public offering wasn’t the kind of high-altitude rocket many investors seemed to be hoping for, it sent shockwaves through the technology sector and the venture-capital industry that are still reverberating. Paul Graham, founder of noted startup incubator Y Combinator, has warned in a note to YC companies that they are going to have to be more cautious now, and other investors have talked about the IPO window for anything social being “slammed shut.” But has Facebook really popped a bubble, or has it just allowed some of the steam to escape from a market that was in danger of becoming overheated?

Much of Graham’s note to Y Combinator startups and founders deals with the intricacies of venture funding — convertible notes and price caps and the potential danger of “down rounds.” But his message is fairly clear: that startups should hang onto whatever money they have already raised so far, and that they should also be very careful about trying to raise any more money at this point, because valuations are likely to have fallen. Says Graham:

If you haven’t raised money yet, lower your expectations for fundraising. How much should you lower them? We don’t know yet how hard it will be to raise money or what will happen to valuations for those who do. Which means it’s more important than ever to be flexible about the valuation you expect and the amount you want to raise

The best place to be is not to need money

As startup advisor Semil Shah noted on Twitter, there’s a reason why companies like Quora, Spotify and Pinterest all raised large amounts of cash in the weeks leading up to the Facebook IPO, when the frenzy of interest around the issue was arguably at its peak. Quora, for example, raised $50 million even though the founders admitted that they didn’t really need it — since they still had more than half their initial funding round sitting untouched in the bank. The best place to be, as Graham notes, is “not to need money.”

Union Square Ventures managing partner Fred Wilson has a somewhat different take from Graham’s in a blog post responding to the Y Combinator note, one that puts the Facebook IPO and its resulting valuation in perspective. As he points out, even after dropping 30 percent from the price it went public at, something that many have described as a disaster — or at least a severe disappointment — Facebook is still worth about $60 billion, or roughly 10 times its estimated annual revenue and 25 times its estimated free cash flow. In other words, still a pretty hefty valuation:

Clearly Facebook is a premium company and commands a premium valuation and entrepreneurs should not expect to get 10x revenues and 25x EBITDA for their companies in a sale or an IPO. But even at half those numbers there are fantastic returns for investors and entreprenuers to be had.

As many technology and investing insiders have noted, Paul Graham’s note is similar to one that legendary Silicon Valley venture fund Sequoia sent out to its portfolio companies in 2008, entitled “RIP Good Times.” Although the slideshow presentation was about the environment created by a variety of macro-economic factors, including the Wall Street derivatives debacle and an overheated housing market, the message was that companies should control their costs and manage their expectations because money was going to be tight.

Good companies will always be worth investing in

That was probably good advice, and focusing on those factors is arguably something companies should do at almost any point in an investing cycle. But as a number of people have pointed out — including internet entrepreneur Russell Fradin, former CEO of Adify — the time following that Sequoia presentation was arguably one of the best times to invest in startups in the past decade. Funds like Union Square and others have made a substantial return on companies like Twitter, Tumblr and of course Facebook itself, and many of those companies don’t seem to have had much difficulty in raising money when they needed to.

In the end, the Facebook IPO and the scepticism it has triggered about internet valuations could be a good thing, if only because it may have corrected some of the over-inflated expectations about anything connected to the social web. In a discussion on Hacker News triggered by Graham’s note, angel investor and startup founder Chris Dixon points out that investing downturns are sometimes a figment of the imagination, and that both companies and investors need to take such pronouncements with a grain of salt:

This happens every couple of years in tech. I’ve personally witnessed 3 downturns now. One was real and two were arguably the best time to start companies. Raising money might be harder, but generally only for bad companies.

Graham himself makes a similar point — namely, that there is a certain Darwinian aspect to the funding cycle. The companies that are most at risk when the financing tap gets turned down a notch, he says, are the ones who spent too much or got irrational during the good times, the ones who have “easy money built into the structure of their company” and therefore “are led to spend a lot and to pay little attention to profitability. That kind of startup gets destroyed when markets tighten up.” Graham’s advice? “Don’t be that startup.”

Post and thumbnail images courtesy of Flickr users Photo Clinique and See-ming Lee

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  1. Jeff Pester Tuesday, June 5, 2012

    No matter how the funding landscape shakes out, one thing for sure is that the pre-IPO froth signaled the peak of the Hype Cycle. The increased scrutiny of Facebook’s ad business and challenges with mobile are forcing the entire ecosystem to take a step back and re-evaluate.

    This reconciliation between the promise and reality of social media is definitely going to let some of the air out of the category. According to the Hype Cycle (http://en.wikipedia.org/wiki/Hype_cycle), we’re headed for the “trough of disillusionment”. Strap in, it’s gonna be a bumpy ride.

  2. Like what Chris Dixon said, “Raising money might be harder, but generally only for bad companies.” Survival of the fittest it is.

  3. This is overall very positive, pushing start-ups to look for positive cash-flow versus incremental funding with hefty valuations based on pure speculation. Ultimately it’ll help gear entrepreneurs back to building value in their market, in sustainable ways…

  4. Hasn’t anyone been paying attention to Amanda Palmer? Change is happening fast enough at this point that rules don’t even have enough time to become rules anymore. Check out her “IPO”:

    http://www.kickstarter.com/projects/amandapalmer/amanda-palmer-the-new-record-art-book-and-tour

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