Xconomist of the Week: Habib Kairouz Foresees a Valuation Correction

A perhaps overused idiom in technology news is to proclaim that the latest bubble is about to burst. While there have been flashy stories about the rise and stumblings of some high profile startups, Habib Kairouz, a managing partner with venture capital firm Rho Ventures in New York, says he believes the market is entering a valuation correction phase, rather than the doom and gloom blowup scenario others see in their digital tea leaves.

Rho makes seed stage and growth equity investments in companies across the country and abroad. Some of the firm’s recent investments include Totsy, Mersana Therapeutics, and JustFab. Kairouz spoke to Xconomy about Rho’s investment strategy and activity in the market he is a bit leery of.

Xconomy: What trends from the innovation scene have you been watching closely this year?

Kairouz: From a capital markets standpoint, we’ve been concerned for a couple of years—most specifically in 2012—about some of the valuations we’ve seen in social media and to a lesser extent software-as-a-service companies. We’ve been concerned about the late-stage valuations for some of the rising stars that have been done with large rounds.

Even though we’ve seen interesting IPOs from companies like Facebook, Zynga, Groupon, and Pandora, there’s been some disconnect with the prices paid for some of these companies in the private market prior to the IPOs. Who’s right and who’s wrong, I have no idea. We’ve been focused on where we’ve seen a gap in the marketplace in the Series B to C stage. We think there’s been a flood of capital at the seed level with too many companies getting funded, which is healthy in terms of innovation but not necessarily promising as to the number of companies getting follow-on capital.

It is more interesting for us as investors to come in during the Series A or Series B rounds before they are proclaimed to be stars and the valuations rise to very high levels.

We’ve had a recent exit with OMGPOP, which is in the gaming space. We’ve made investments recently in companies like GetGlue in social TV. This is a space we are very excited about. We think it is the next big disruption in media. GetGlue allows consumers to interact with their TV programming by adding a new layer where people use their iPads and iPhones to vote on shows such as “American Idol” or have social TV conversations. We’ve also made an investment in Dashlane, which is an early-stage company that addresses the problems consumers have managing their IDs and passwords on the Web.

X: You have invested in e-commerce as well with companies such as JustFab.

K: We also have two others in New York: Totsy and Bluefly, which was one of the first e-commerce companies to emerge in the late 1990s. We also invested in a company out of Canada called Beyond the Rack. [Totsy in New York is a flash sale site for deals on products for infants, kids, and parents. Bluefly (Nasdaq:BFLY) in New York is a fashion e-tailer. Beyond the Rack is an online shopping club for apparel, consumer electronics, and home décor.]

X: Given your concerns about valuations, do you believe we are in a bubble?

K: I’m not necessarily concerned about a bubble phenomenon. In my mind what happened in the late 1990s was extravagant valuations and the huge promise of value creation [based] on the commercialization of the Internet. People were putting together billion-dollar valuations while ignoring cash flows that weren’t going to happen for 20 years.

Today you have Facebook, Groupon, and Zynga as rising stars of Web 2.0 value creation. All these companies have unbelievable scale in terms of revenue and that’s only from the past five years. We’re all criticizing what’s happened to those companies post-IPO, except for maybe LinkedIn.

People are losing sight of the fact they are generating millions and in some cases billions of dollars. That is incredible value creation. Most of them are profitable or heading towards profitability. I don’t view that as a bubble. Where we worry is people putting very high valuations on some of these companies assuming the growth rates will continue as they have in the past.

There’s nothing wrong with a company that grew 200 percent in year one, 100 percent in year two, 80 percent in year three, and is tapering off to a 40 or 50 percent growth rate. When you assume they are going to continue at 100 percent for the next 10 years and base the valuation on that, that’s where we [Rho] get off the bus.

I don’t think it’s a bubble; it’s a valuation correction that reflects the fact that some of these companies will have lower growth rates in the future. Some of them will not be as successful as their competitors. People tend to extrapolate valuation by pointing to one success story in a very specific market and assume that others will be able to replicate it. That’s what I worry about in the late stage round. I think we’re already seeing a correction.

The other thing we worry about at the seed level is a lot of people have invested just because they met a very charismatic entrepreneur with an interesting idea. I worry that many angel investors will lose money. Some of them have been very successful because they are connected to networks of entrepreneurs. But many of these companies are not going to get the follow-on, institutional rounds. I don’t worry about that as much because the seed category represents less than 5 percent of venture capital dollars.

X: Do you see any long-term repercussions of this valuation correction?

K: I think we’re going to an environment that is much more positive for the asset class, entrepreneurs, and innovation than in decades. Venture capital as a category is rebounding very nicely. You have fewer competitors going at it in terms of the number of firms investing, and returns have been picking up in the last couple of years. From an innovation standpoint, we see an incredible amount of exciting new ideas in Internet, wireless data, connected TV, video, social media, and e-commerce. The last decade has been about digesting and sifting through the survivors of the last bubble. The quality of entrepreneurs is getting better every year. In New York back in the late 1990s, 90 percent of the entrepreneurs we met were first-timers trying to jump on the gold rush bandwagon. Now maybe 20 percent of those entrepreneurs are still in the game. They came back, were successful with their second ventures, and then moved onto their third and fourth ventures.

X: Are there other parts of the country where new innovation hubs are emerging?

K: New York is becoming our second major market [after Silicon Valley]. Our portfolio here continues to grow. We’re doing less in markets like Texas and Boston than we did in the 1990s. We’re doing more in emerging technology markets like Canada. We opened a dedicated office and fund in Montreal. We’ve raised two funds there so far. We’ve also invested opportunistically in companies overseas in Israel, Paris, and London. We’ve looked at companies in Brazil. Typically, those companies want a path into the U.S. market. Even if they keep their engineering and early-stage operations overseas they ultimately end up opening a front office in the U.S.

X: What trends and sectors will you watch in this latter part of the year?

K: My focus right now is connected TVs: the applications and innovations that are going to come out from that wave of disruption. We’re spending quite a bit of time on wireless data and applications. We had a big investment in Tapjoy, which is a platform for the discovery of social and mobile games. We’re not chasing companies that have already been declared winners in their sectors. We focus on the ones that need to achieve some milestones before they hit their inflection points.

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