Jul 2, 2015 ยท 10 minutes

When Josh Kopelman's letter to First Round LPs leaked this week, a lot of focus was given to his chatter about bubbles and unicorns.

Referencing The Wall Street Journal’s tracking of unicorns at the start of 2014, Kopelman wrote, “At the time, there were 42 unicorns. Just one year later, the unicorn population has more than doubled to a total of 87 unicorns. Yes, it seems that a new unicorn was created every 9 days last year!”

Kopelman added, “This is a tremendous shift in the way that startup companies get valued -- and funded.”

Sounds great right? Well, not so much for early stage investors because, barring a few outliers, the actual exit values have not increased. In fact, it’s the most sobering view of seed investing since the fear over the Series A crunch.

From the the First Round letter:

We predict that the market-average seed stage valuation in 2015 will be almost 3x higher than it was when we raised our first institutional fund in 2007. That takes what would have been a 3x fund in 2007 and makes it a 1x fund in 2015 (assuming no increase in exit values). And it means that the seed-stage industry as a whole will see a 3x decrease in returns (again, assuming no increase in exit values) in the next several years.

We don’t have a crystal ball -- and we can’t forecast the future -- but we do have a calculator. The simple math of venture investing says that only two numbers determine an investment’s return: the entry price and the exit price. And while 2014 showed a slight uptick in total exit values for the industry (mainly due to the $19B acquisition of WhatsApp), total exit values have not increase anywhere near the pace of entry values. Indeed, the total value of M&A exits in 2013 was less than it was in 2007, and public markets still remain relatively closed to technology companies.

So what is causing all this bullshit math and high valuations that seems to be ruining the market?

The answer is right there in the second paragraph above.

It’s the $19 billion exit for WhatsApp when it was acquired by Facebook -- an exit which is now considerably higher at an estimated $22 billion or more, due to Facebook’s stock performance.

In the perpetual penis measuring contest that has become venture-backed valuations and exits, WhatsApp is the king shit -- which is kind of funny because WhatsApp wasn’t an Uber-like darling of the venture world. It only raised a little more than $58 million in three rounds, which is nothing compared to what companies that have a fraction of WhatsApp’s eventual value have raised. And the messaging app can’t even compare on a business strategy level. That’s because it had the audacity to charge users for a valuable service and therefore didn’t need $1 billion in venture capital.

To paraphrase Kopelman’s letter, there are two numbers that matter: The amount going in (and yes, the price paid) and how much comes out. WhatsApp was a magical outlier on both.

According to a CB Insights report on the 2014 exit activity of privately-backed companies, the WhatsApp deal and the IPO of the Chinese company JD.com made the exit dollar amounts for the first half of the year three times greater than the exit numbers in the second half. By CB Insights account, the current $22 billion value of the WhatsApp=Facebook deal is more than four times greater than the next closest 2014 exit, which was Lending Club’s IPO.

Although WhatsApp isn't the sole reason for the current frothy state of the venture market, what the acquisition did was reset the dollar amount of what's considered a “big purchase” for an up-and-coming Internet company by a massive corporate giant threatened by it. It used to be closer to $1 billion: Whether that was the $1 billion Yahoo tried to buy Facebook for once upon a time, the $1.6 billion Google paid for YouTube, or the $1 billion Facebook paid for Instagram. The two latter deals were seen as culturally-transformative moves for the companies. Imagine a world where Twitter bought Instagram and Facebook didn’t. And WhatsApp was worth a staggering 19 Instagrams.

The deal changed the way VCs thought about exits, not too differently from how Netscape’s IPO changed what 18-month-old Internet companies could be worth to investors. Sure, it’s a gargantuan outlier. We didn’t see a flood of WhatsApp-sized deals come next. But this is an industry where the top-end economics are delivered by outliers, so likewise they can’t be dismissed.

But the sheer size of the deal has had a distorting effect on the whole market, trickling all the way down to the early stage funding climate; not in terms of actual returns, mind you, but in terms of optics and perception, and how VCs are starting to structure their funds to take advantage of the next “outlier.”

It seems that Facebook’s acquisition of WhatsApp has affected the venture-backed technology market in three ways: exit psychology, the velocity of deal flow, and valuations.

Waiting on a big win

The current state of the venture scene is similar to a phenomenon that happens in sports. In 2013, Peyton Manning re-took the top spot as the NFL’s highest-paid player -- with a $15 million per year contract -- a year after Dwight Freeney had knocked Manning from the same position of being the highest paid. Currently, Green Bay Packer Aaron Rodgers is the highest-paid player with a $22 million annual contract.

With no other measuring stick, the startup and VC world -- and, let’s be honest here, the tech media -- has relied on a company's valuation as an indication of status. Profits and revenues are subject to wildly differing measuring stick depending on the space, and most of the other stats that do matter are too opaque to anyone on the outside of a company. “Crushing it” isn’t quite nuanced enough. Think about how often companies tout their status on the Fortune 500 -- or 5000 or 50,000, ad infinitum -- or how proud some VCs are to hold a certain status on the Midas List.

And so with that $19 billion number hanging in the air like an unattainable WWE Championship belt in a metaphorical Silicon Valley no-holds-barred ladder match, things have changed quite drastically in a little less than a year and a half.

The bar has been set to an almost unattainable height, and the normally cyclical nature of the VC-backed tech ecosystem is slowly coming to a halt.

On one end of the spectrum, no one is exiting either through IPOs or M&A. Another CB Insights report from a little over a month ago showed that there were 18 M&A exits for more than $30 billion dollars for the period between January 1 and May 22 in 2014; during the same period this year, there were four exits valued at $1.5 billion.

Even taking WhatsApp out of last year’s numbers, there were still more than four times as many exits and, at a minimum, four times as much money involved. The IPO activity for tech companies has been even worse in 2015 compared to the same period last year.

Maybe there is a fear of the public markets, or maybe some companies have priced themselves out of being acquired. But it could also be the Peyton Manning-phenomenon. None of the big names have yet to find the deal that can knock the WhatsApp acquisition from its perch.

Unicorns multiplying like rabbits

Looking at the numbers from CB Insights and PitchBook that analyze VC deals, M&A, and unicorns over the past two years, a few more trends reflect shifts in the market climate following the WhatsApp sale.

In the two years prior to the February 20, 2014 announcement that Facebook had acquired WhatsApp, 18 VC-backed companies achieved the billion dollar unicorn status. Since, there have been 82 companies that have valuations making them unicorns. Of the 116 private companies on CB Insights’ unicorn tracker, only 34 joined the unicorn club prior to the WhatsApp acquisition. This is to say nothing of the new “deca-unicorn” club that includes Uber, Kuaidi Dache, and Snapchat.

Part of what's driving these super-billion dollar valuations is the prestige that comes with being in this elite group. But what's also pushing up valuations and, by proxy, the size of investment rounds from seed to late stage, is that the market averages have been skewed by an extreme outlier. $1 billion isn’t the $1 billion it was when Google bought YouTube, or Facebook bought Instagram.

Just imagine how crazy Facebook’s $2 billion purchase of Oculus would have seemed if WhatsApp hadn’t just reset the bar of what Facebook was willing to pay for the right deal. That may seem like mere “perception” but perception can drive Wall Street’s acceptance of a deal or a company’s justification of it.

CB Insights 2014 year-end analysis also showed that January and February of 2014 didn’t veer too far from the 2013 month-to-month trend in the amount of venture money invested. Starting in March of 2014, a week after the WhatsApp deal was announced on February 20, the activity increased greatly each month, with a lull in the late summer and early fall, and a huge December that saw more than double the amount of venture capital invested than in any month over the past two years prior to March 2014.

There are many companies right now that have excessively high valuations and that are more likely to IPO than to be part of any M&A deal, including Xiaomi, Uber, Airbnb, Palantir, and Snapchat. But maybe there have been offers for some lesser unicorns and decacorns that were passed up because companies and VCs have their eyes on the WhatsApp prize --like Snapchat. It’s a lot more appealing to be “three Instagrams” than “a fraction of a WhatsApp.”

Oversized valuations

The reverberations of the WhatsApp acquisition are being felt all over. VC data recently released by PitchBook shows that the median valuations for seed stage startups have risen by half a million in one year, from $5.7 million in Q2 2014 to $6.3 million. At later stages, the difference is even greater. The median valuation for Series B rounds in the second quarter in 2014 was $35 million. This has now jumped to $60 million. Meanwhile, the median change in late stage valuations -- D rounds and beyond -- went from about $158 million in Q2 of 2014 to around $253 million in Q2 of 2015.

Valuations are getting larger and larger, and while the vast difference is most shocking when looking at the change in late stage deals, the bigger problem for the health of the tech economy may be in the developments for early stage investing. Seed deals, which in 2010 values early stage companies in the ballpark of $3 million, have risen to a median seed valuation just shy of $6 million in 2014 -- a level where many angels could be getting priced out of deals, or rounds are getting oversubscribed creating cap table chaos. A side effect is the explosion in micro-VCs trying to get into venture deals before more established firms. While economically there is nothing wrong with that, an unintended consequence could be an influx of greener VC mentors who lack the experience of established early stage investors like First Round, Accomplice (Atlas), and others, and who will therefore bring fewer non-financial benefits to burgeoning businesses.

The WhatsApp-Facebook deal certainly isn’t the cause of the crazy funding and valuation numbers being seen these days, anymore than Netscape created the dot com bubble.

However, February 2014 is as good of a time as any to point to as the moment when the tech bubble started to balloon to the point of an explosion -- an explosion that many feel could happen at any moment.