Don’t Panic, Software is Still Eating the World. Time to Rethink Everything.

Facebook is $11.50 down from it’s opening price of $38.00. Fred Wilson wrote a great post with some perspective on the enterprise value of FB and how it’s value is appropriate based on the revenue and EBITA multiples. Paul Graham has also written a memo on the Facebook Fallout, which states that the Facebook IPO will lead to a difficult fundraising environment. I don’t disagree that the FB could have an impact on valuations in the later stage and secondary markets (per Fred Wilson), and I also believe that the effect will trickle through the market and have the biggest impact in the very early stages. The market has been frothy for some time, and a correction is expected. On the other hand, the “Facebook Fallout” will have next to no effect on the capital allocated in institutional rounds. Here’s why:

VCs invest consistently over time.

VCs worth their salt don’t try to time the market. The “flippers” who are looking to make  investment and sell quick aren’t real VCs and won’t be around for long. A true VC will take an active role in it’s portfolio companies and help build it into a company of value over. It takes several YEARS of value creation before an exit is feasible, making it impossible to time the markets. Fred Wilson has written a good deal about a consistent investment strategy.

VC dollars are close to equilibrium

VC fundraising is also up. In 2011, 181 funds raised $18.8B, compared to 2010, where 170 funds raised $13.8B. These VC firms will be looking to allocate this new capital over a 3 to 5 year period. It’s arguable but there is some indication that the equilibrium number for VC dollars raised and allocated is just under $20B/yr. Given the current level of activity I don’t foresee a huge disruption in the amount of dollars raised and allocated by institutional firms.

Why will there be lower valuations? And what is Paul Graham talking about? 

Valuations in the IPO and secondary market may be adjusted based on the Facebook market value. These lower values will force down values in the prior round which will eventually trickle down to the early stages. But it will be the angel round that takes the biggest blow as the number of active angel decreases.

Angels invest their own money, usually on a part time basis. Unlike a VC, who must allocate capital within a specific time frame, an Angel has no requirement to make an investment. When the market is “hot” and angels are getting big mark ups on subsequent rounds they invest more. The increase in activity has been prevalent over the last few years. Accoring to Jeffery Sohl, director of UNH Center for Venture Research “The significant increase in total dollars, coupled with the rise in the number of investments resulted in a larger deal size for 2011.” The cycle of angel investment activity unravels fairly quickly when a catalytic event occurs that resets market prices. This what Graham means when he says the markets are going to tighten up.

What should you do?

If you’ve raised money at a valuation higher than the upper end of normal, or skipped a step in the start up process, shame on you. There isn’t much you can do, you can’t control the market. But this doesn’t mean you should give up, it simply means you need to continue to build a company of value. The price of Facebook isn’t going to affect the execution of your startup or the happiness you deliver to your customers. Focus on building your business, hit your milestones, acquire new customers and prove out your business model. There is no need to panic, software is still eating the world, time to rethink everything.