Living in a bubble: valuation trends to watch in 2014

Just when it seemed as though start-up valuations had peaked in 2013, the year 2014 has started with an opening shot in the form of the reported US$3.2 billion acquisition of Nest Labs by Google. It now looks as if this year will bring about perfect-storm conditions, which will sustain the trend of high valuations for exits (M&A and initial public offerings (IPOs)) and transactions in coveted markets such as the Internet of Things, where Nest has a strong foothold. We live in exciting times, when disruptive technologies finally meet the right market conditions and capital infrastructure that allow for the kind of unprecedented valuations witnessed in recent years. 

From my vantage point in Silicon Valley, I am frequently asked whether we are in the midst of a 'valuation bubble'. The answer to that goes back to the definition of a 'bubble', which inherently involves some irrational behaviour driving otherwise rational participants in the marketplace to stray from prudent and reasonable prices that could have been anticipated under similar circumstances. Understanding the factors driving business valuations in general, and the value of intellectual property and technology in particular, starts with understanding the valuation framework, access to capital, liquidity conditions and the overall technology landscape. With that in mind, let’s look at some of the major trends that are likely to shape valuations in 2014 in order to work out whether current valuation levels actually represent irrational, bubble-like conditions.

Demise of financial fundamentals: rise of KPI-driven valuations
Valuations in certain high-growth industries are undergoing a paradigm shift, with financial fundamentals making room for valuations based on key performance indicators (KPIs) such as user stickiness, churn and conversion rates. A common pitfall involves trying to benchmark valuations of pre-revenue companies against traditional financial valuation fundamentals, such as revenues and profit multiples. This may sound like a radical idea, but it is the only way to explain the price parity between Instagram and Ducati, two companies purchased on the same week in April 2012 for around US$1 billon. Instagram, a high-flying social media start-up with no revenues and 50 million users, commanded the same price as Ducati, a century-old Italian motorcycle manufacturer with €500 million in revenues. Last year saw a proliferation of KPI-driven valuations, with pre-revenue start-ups such as SnapChat and Pinterest valued at billions of dollars. This trend is expected to continue into 2014. 

JOBS Act and crowdfunding: new platforms for funding innovation
Reward-based and equity-based crowdfunding platforms are emerging as prominent means for funding innovation, with over US$2.7 billion raised in more than 1 million campaigns across all types of crowdfunding platform in 2012. Equity-based crowdfunding was made possible by the Jumpstart Our Business Startups (JOBS) Act, which lifted the 80-year ban on public solicitation in the United States. The long-awaited equity crowdfunding Title III Securities and Exchange Commission regulations are expected to be released in 2014, marking the full launch of equity crowdfunding in the United States. At the same time, reward-based crowdfunding is becoming increasingly popular, with major platforms such as Indiegogo and Kickstarter helping start-ups to raise millions of dollars and bring new products to market. Crowdfunding is expected to result in a higher level of transparency in early-stage valuations, as the JOBS Act requires the submission of a business plan and share valuation estimates.

Supply and demand: cash is abundant
As 2014 rolls in, the consensus in US investment circles is that there is a lot of cash on the sidelines waiting to be deployed. Several factors are at play here: corporate cash levels are at an all-time high, creating shareholder pressure; high liquidity is fuelling private equity investors, which are moving into growth equity; and venture capital investors are increasing their funds, resulting in higher investment rounds. The abundance of cash for investment is pushing up valuations to higher levels across the board - a trend that is expected to continue into 2014. 

Multiple paths to liquidity: intense M&A and IPO activity
In 2013 the NYSE reported a total of 230 IPOs with a combined value of over US$55 billion across all major US stock exchanges. Companies going public in the United States are generally more mature and are staying private longer. Subsequently, pre-IPO liquidity in secondary markets is very important, especially to early shareholders and investors. M&A activity saw some decline in 2013, with slightly over 10,000 deals reported overall, including about 2,200 technology deals with a combined value in excess of US$100 billion. IPOs and M&A deals represent alternative paths to liquidity, which drive valuations up as companies have several options. These pricing pressures are expected to continue through 2014.

Technology sectors to watch in 2014: major disruption ahead
Some technology sectors represent particularly high-growth opportunities, and are expected to rise above the tide and generate M&A activity and higher valuations in 2014. One such sector is the Internet of Things. The Internet of Things represents the vision of a connected universe where objects, devices and people will all share a common network of communication. IDC estimates that the number of connected devices will grow to 212 billion by 2020, with about 30 billion devices smart enough to operate without human control. A study by GE concluded that the Internet of Things market over the next 20 years could add as much as US$15 trillion to global gross domestic product, which is roughly the size of the current US economy. The Internet of Things is gaining momentum with industry leaders such as GE and Cisco, which adopted it as a key element of their corporate vision in 2014 and beyond.

I will leave it to IAM readers to make their own determination regarding the valuation bubble. My personal opinion is that the answer is somewhere in the middle, and perhaps we could characterise current valuation levels as “somewhat inflated, but mostly expected” under existing market conditions. I will monitor these trends as I explore IP and business valuation topics throughout 2014.

This is an Insight article, written by a selected partner as part of IAM's co-published content. Read more on Insight

Unlock unlimited access to all IAM content