Tech startup balloon may deflate rather than burst

At a time when the startup ecosystem is flourishing and valuations for many ventures are soaring, a few people feel a crash is inevitable. But two general partners at a top venture capital firm believe startups should be more concerned about a deflation rather than a sudden burst.

In a recent podcast, KPCB's Randy Komisar and Ted Schlein discussed their views on unicorns – startups with a valuation of $1 billion or more – and said that the market is certainly overheated.

Kleiner Perkins Caufield & Byers (KPCB) is venture capital firm located in Silicon Valley. The 43-year-old firms specializes in investments in incubation and early-stage companies, and has backed more than 500 ventures including AOL, Amazon, Compaq and Zynga.

Potential and performance

While startups are touching insane valuations in private markets as they raise higher amounts in subsequent funding rounds, Komisar and Schlien believe the trend in public markets will be different. Sanity will prevail in the private sector as long as the public markets remain sane, they feel.

Though private valuations are driven by potential, IPO valuations are judged by performance. While the market loves bubbles and bursts, Komisar and Schlein believe that what's going on is more of a cycle rather than a bubble and that the cycle has become a little overheated. They highlight that it's more a question of a balloon deflating rather than a balloon popping out.

Public markets will act as regulators and companies not raising enough from their IPOs will drive down private valuations for others

A question that baffles them is how companies are able to stay private for long. While the trend has helped companies survive subsequent rounds of higher valuations, Komisar and Schlein point out that there is not enough money in the private and public markets for companies to keep deriving higher valuations.

They feel that another problem with raising too much capital is that this increases the chances of failure. Unicorns have to live up to the valuation and raising too much money limits their business opportunity.

While the entrepreneur may have raised money and minimized dilution, the large valuation makes it even harder to become a public company or get acquired. Acquirers, especially public companies, must behave rationally, they believe.

High valuation is not important finding the right investor is; momentum is more important than higher capital

Spend and grow has been the strategy for entrepreneurs as they burn more and more cash on their businesses. What's important is to get the right balance. The business model should be to save when times are frothy and capital is freely available.

Komisar and Schlein say that markets are concerned more with valuations than innovation and disruption. This has created a false mark for most companies as they have strayed from their path of innovation and disruption. Entrepreneurs should ask questions such as what to do with the next round of capital and whether hiring more is the key before raising more cash.

Companies have to start looking to become cash neutral, they say. The smarter thing to do would be to not raise debt to run a company as loans with no fiscal responsibility can lead to rights going in the hands of lenders.

Operations should be run from equity holding or from revenue generated from business; the end game is to create real value

While Komisar and Schlein mostly highlight the issues pertaining to an entrepreneur, they also point out that VCs are equally to be blamed for the high valuations. They believe that although the VC business has been successful, yet most firms have not been able to make money for their clients and this has led to riskier bets in the market.

They point to the irrational exuberance and say that, because there are only a few VCs who make money, there are some who decide they need a miracle and drive the stakes higher for the rest of the market.

Behave rationally in an irrational market. It's okay to draw lower valuations provided you can maintain a steady flow