Opinion

Felix Salmon

Art, venture capital, and down-round phobia

By Felix Salmon
July 16, 2013

Ben Horowitz has a great guide to the dreaded “down round” today — that unloved point in the evolution of a venture-backed technology company when it’s forced to raise money at a lower valuation than it received in previous rounds. Certainly, such things shouldn’t be unexpected. As he explains:

The average company on the S&P 500 IT index with $10 million in annual earnings would be worth $210 million in March of 1995, $820 million in March of 2002, $310 million in March of 2004, and $155 million in March of last year. And those are big companies with real earnings, so you can imagine how a private company’s valuation might fluctuate.

Still, Horowitz likens the experience to being “the captain of the Titanic”, and he notes that it only starts looking attractive when you realize that the alternative is “suicide”: “Down rounds are bad and hit founders disproportionately hard,” he writes, “but they are not as bad as bankruptcy.” And he notes, in a clear-eyed fashion, that it would take a “miracle” for a founder to survive the process. (Startup founders are short-lived at the best of times; it’s rare they can survive a down round.)

The problem here is clear: a simple lack of honesty and transparency when it comes to funding. Valuations go up and down, but no one likes to admit it; investors, in particular, love to delude themselves that the value of the company only went up after they bought in, and that they got a spectacular deal.

Indeed, this is one of the reasons why so many startups fail: taking VC money is a deal whereby, in practice, if you don’t grow super-fast, in both size and valuation, then you will be left for dead. David Segal, on Sunday, had an intriguing piece about what you might call distressed startup opportunities, but that’s a very, very new market, and one which VCs aren’t yet interested in. For the most part, VCs all operate according to the same convention, which treats downward valuation fluctuations not as some natural occurrence but rather as a mortal threat.

When I was reading Horowitz’s piece, I couldn’t help but be reminded of Allison Schrager’s article about how “high-end art is one of the most manipulated markets in the world”. Again, the problem is that the art market isn’t allowed, by its practitioners, to be a real market, and instead operates on a series of conventions which make it deeply broken on many levels.

There are two startling data points Schrager’s piece. The first shows that it doesn’t have to be this way: in China, she says, 50% of primary sales — sales of fresh works, which have never been sold before — take place at auction. That certainly helps explain why Chinese artists are so dominant in the contemporary-art auction-volume league tables.

The second is a story which shows what happens when artworks are not sold at auction: they can sell instead for a discount of 99%.

A few years ago a young art collector from New York I know bought a painting from a New York gallery. A few weeks later she went to the Miami Basel art fair where a celebrity heard about the painting. He offered to buy it for more than 50 times what she paid for it. She refused and he raised his offer to a sum that would mean she’d never have to work again. She explained that she would not bargain with him—any resale of the painting must go through the gallery, so they’ll get a commission and select the price—not her. The young collector knew there would be consequences to making the sale. She may have owned the painting, but reselling it at a profit without the gallery’s permission would blackball her from the art industry. To her, that was not worth the millions she was offered.

There are a lot of lessons to be drawn from this story, including of course the fact that we’ve been deep in bubble territory for at least “a few years” now. But mostly, it’s one of those unfalsifiable anecdotal beauties which the small and gossipy art world requires even more than it does money. Put aside the question of whether it’s literally true — that really doesn’t matter. What matters is the art-world conventions which are revealed here.

First is the way in which social currency — whom you know — trumps actual currency. The young collector in this story made a simple calculation: the value of a good relationship with the gallery in question was higher than the millions of dollars dangled in front of her by the celebrity. And of course the value of social currency is the reason why the celebrity was in Miami in the first place, too. The monster success of global art fairs like Art Basel Miami Beach, which have pretty much eaten the entire art world at this point, is ostensibly about commerce — but in reality has just as much, if not more, to do with the fact that they’re a way of getting a far-flung crowd together in the same place at the same time. For all the financial deals which are struck at art fairs, there’s just as much value, if not more, created in the social ties found at the endless round of parties and dinners at such occasions. In many ways, the spectacle of Jay-Z performing at Pace Gallery for six hours last week was his way of buying social currency in the art world — essentially, buying himself the option to lay out huge sums of cash for work by hot young artists.

Art, then, is very similar to venture capital, insofar as who you know matters — and also insofar as both markets go to great lengths to hide natural valuation fluctuations. “Down rounds” are if anything even more harmful to an artist than they are to a startup: galleries will, as a rule, drop an artist before selling her art for less than she was charging at her previous show. The reason is entirely to protect the gallery’s own credibility: the gallery wants collectors to see it as a place where they can buy art which is going to rise in value, and as a result it will do everything in its power to make it look as though the work of all of its artists is only ever going up in price rather than down.

Horowitz concludes his piece by saying this:

The only surefire antidote to capital market climate change is positive cash flow. If you generate cash, investors mean nothing. If you do not, then your success will depend upon the kindness of strangers.

Apply that lesson to the art world, and the conclusion is clear. No art has positive cash flow; ergo, all artists are dependent upon the kindness of strangers. Schrager takes this idea to its logical conclusion, considering — and then rejecting — the idea that an old-fashioned patronage model might be better for artists than the current grinfuck model.

She’s probably right about that, although there are certainly artists who quietly do quite well for themselves on the patronage model, selling their work directly to a small number of collectors and bypassing the craziness of the gallery system. Those collectors are well aware that the artists in question aren’t going to become auction-house stars, but that’s OK: they’re buying art for the right reason, because they love it, rather than for mercenary reasons surrounding dreams of future wealth.

The question is whether a more transparently market-based system, one where people understood that prices can fluctuate, would be better for artists than the current system, where artists’ careers, a bit like startup valuations, have to always be improving lest they fall into the art-world equivalent of bankruptcy. Schrager thinks it might be:

If pricing were transparent, it would probably be lower and art more available to a wider range of collectors. This would be an unwelcome move for dealers and elite artists but it could also demystify the market and lower tier artists could earn more because the market would be less segmented. To some extent technology is naturally making it happen. Websites are cropping up that sell primary art and make it more available to the masses. Even Amazon has set its sights on the art market. It plans to partner with certain galleries to sell some of their inventory online but it’s not clear whether it will become a “market for lemons,” where the best pieces from the most promising artists are still reserved for certain collectors and prices of promising emerging artists still unknown.

I’m not holding my breath: the art market, more than ever, is controlled by a handful of large international galleries, and those galleries have no incentive whatsoever to give up their pricing power. Doing so might be good for artists, just as transparency around fluctuating valuations would probably be good for startups. But it’s not going to happen.

Comments
5 comments so far | RSS Comments RSS

I think that this analogy is interesting.

The other issue with VC round valuations is that they are, to some significant degree, BS in the first place.

The reason is that, in a typical VC deal, the VC invests in preferred security of some sort. Details vary, but a typical structure is preferred stock that’s convertible into common stock at a fixed price, has a liquidation preference equal to the investment amount, may have an accruing dividend on top of that, and has some mechanism for forced conversion of the security upon a liquidity event (IPO or sale) above a certain valuation (often the initial conversion price, sometimes higher).

So, in a Series A, for example, say that $10 million is invested. Assume that all other shares are common stock, which is a reasonable assumption. If that $10 million of Series A Preferred Stock is convertible into 20% of the total fully-diluted shares of common stock, someone will say that the post-money valuation is $50 million ($10 million divided by 20%). As I say, there’s a large amount of BS to that, because it says that a highly-structured security with more rights than common stock, and economic advantages in low-value exit scenarios, is worth no more than the common stock into which its convertible. That’s not true: the common is worth some amount less, though the discount is hard to quantify. Since the common is worth less, the company is worth less than the reported $50 million post-money valuation.

Posted by realist50 | Report as abusive
 

One other thought about Horowitz’s column.

For reasons of either brevity, simplicity, or self-interest, he fails to mention one reason that a down round is such a mess in VC deals. As I said in my other comment, most VC fundings are structured as convertible preferred, so convertible into common at some conversion price. It is also normal that this conversion price is adjusted downward – i.e., the convertible preferred owns more of the company – if the company ever sells common (or securities convertible into common) at a lower price. Different deals have different ways to calculate of this “ratchet”, some more dilutive than others.

The point is, however, that a down round can crush common shareholders – a group that includes the Company’s founders and employees – due to dilution. That’s particularly likely to be true if the company has raised multiple rounds – let’s say it has issued Series A, Series B, and Series C Preferreds – in which a case a meaningfully down Series D round can be massively dilutive.

Posted by realist50 | Report as abusive
 

the thing that lets you know that anecdote is not “literally true” is that it is alleging that someone was at Basel Art Miami who used the phrase “never have to work again”, thus suggesting that they were familiar with the concept “having to work”.

Posted by dsquared | Report as abusive
 

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Posted by Anonymous | Report as abusive
 

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