Buckle Up for the Next Chapter

I don't want to pile onto or repeat some of the great posts of the current market conditions. Fred Wilson's post, Storm Clouds, was one of the better initial snippets on what is going on. One of the advantages of being in Chicago is that we are the first to lose liquidity and the last to get it. So, we track the number of term sheets from the Valley hitting Chicago as an indication of froth. When it goes up, we know that the Valley has so messed up its ecosystem that they are willing to fly in Winter to Chicago. The planes have been flying in with significant frequency, some driven by the Groupon halo and some driven by a hunger for deals at 50% the price of the Valley. I made the call in June 2008 that the cycle had ended and to buckle up:  Rough Ride Ahead.  I am not prognosticator but rather a risk handicapper. I still believe the next 5 years will produce some amazing wins but we will have a rough interim period here in the next year or so.

Having survived three VC cycles, the pattern is usually the same.

In Stage One, fear sets into the market when the public markets pull back and VC's grow concerned that they won't get exits. They stop feeding the funnel. Valuations fall in the Valley and they pull back their activities to their "two hour radius".  The markets eventually stabilize and VC's come out with a more cautious approach, often looking hard at core fundamentals, take extended periods of time on diligence and price deals somewhat conservatively. Recruiting of talent is rational and effective.

Stage two, the market starts to heat up, companies start to ramp, revenue grows and VC's start to pick up their activity. They have moved from fear to semi-greed.

Eventually, in stage three, a couple of deals pop in a big way (Groupon, Facebook, Playdom, Zynga, etc). Suddenly the VC's begin to get greed and fearful that they are going to miss the next big win. They start pricing deals not at core fundamentals today but at expect or hoped for revenue in the future. If the deals inflect they look like heros and if not, they have a portfolio of destroyed cap tables.

Indicators of Stage Three are:

— frequent "pre-emptive" rounds at 50-100% the expected valuation to "take the deal off the market"

— high valuations in excess of historical norms ($5m revenue, $50m pre-$, $20m revenue-$200m pre-$)

— general sense of anxiety and envy in the Valley with fear of missing the next Facebook dominates partner discussions on Monday's

— talent wars with pricing on salary, tenure shrinks

Well, guess what, we have a lot of term sheets hitting Chicago, talent wars are resulting in Google engineers getting paid $3m+ not to leave, valuations are insane and momentum investing in vogue (term sheets after 2-3 days). My suggestion to VC's is to wait for you pitch and it may be a bit of time before things come back around. My belief is the leading indicator will be an increasing rate of IPO efforts and perhaps a market pull back. Be smart and be ware…  That said the revolution is still alive and strong!