There is no doubt in my mind that venture valuations have become incredibly stretched.  I have been thinking about why that is and what will come of it.

First off, here are the factors contributing to the stretching of valuations.  It starts with the genuine potential for building hugely valuable businesses, which is based on four key factors:

1. The immense possibility for scale on the Internet – global businesses with millions of customers can be created in relatively short time periods.

2. The huge operating leverage of many Internet business models, such as marketplaces, which have near zero marginal cost.

3. The potential to disrupt large markets, such as eduction and finance, with Internet based business models.

4. The winner-take-all nature of network-effects businesses in which the dominant business can be an order of magnitude more valuable than other competitors.

The fourth of these factors leads to an interesting interaction with the economics of the venture capital market to spur on valuations: If given a choice of investing in the perceived leader in a market versus one of the followers, a venture investor should be willing to pay a significant premium.  In fact, if the leader can be expected to be 10x as valuable, then even paying up by 5x will still produce a return that is 2x better than investing in the number 2 or 3 company.

So it is entirely rational given the Internet environment to see a dramatic stretching of the valuations for market leaders with network effects. It does, however, not bode well for aggregate returns for the venture capital asset class:

1. In a race to pick the winners ever earlier, valuations get stretched even for companies that have not yet proven that they really have strong network effects and that they will be the leader in their respective market.

2. These stretched early stage valuations will lead to depressed returns in a large number of companies and will also make many of these companies harder to fund.  There will be more of these companies and more capital invested in them (in aggregate) than in the winners.

This also isn’t great for entrepreneurs who happen not to be one of the market leaders.  They will have financed their businesses at too high a valuation along the way and will either face highly dilutive down rounds or in quite a few cases will find themselves with businesses that are hard to finance altogether (if they have taken their burn rates up too much).

All of this is reminiscent of other markets with strong winner-take-all effects, such as professional sports leagues or movies. The economics for a few winning teams or blockbusters are great but industry aggregates are terrible.  It is a prisoners’ dilemma type of situation where everyone is behaving individually rational but we wind up with a collectively undesirable outcome.  Investing at a significantly higher price for a perceived winner is rational for both the VC firm and the entrepreneur on any specific deal.

The situation is further compounded by the internal structure of VC firms and the overall financial market:

1. There are well-known agency problems between the GPs and LPs of venture firms.  Because of management fees, the GPs’ payout profile is relatively insensitive to entry valuations (for all outcomes that produce sufficient fund returns to raise a subsequent fund) and above that actually encourages swinging for the fences (remember that paying 5x for a winner in the example above still produces a 2x better return).

2. Most large LPs are themselves institutions (pension funds, endowments, etc) which suffer from internal agency problems which contribute to a concentration of capital among fewer venture capital funds.

3. The rates of return available on many other investments are at historic lows and/or suffer from much higher volatility, resulting in an acceleration of capital flows back in to venture capital.

Given these contributing factors and that this is a rational bubble, we can expect it to continue for quite some time until there is either an external shock (the European debt crisis might yet be that shock) or the collective returns become so bad that there is an endogenous correction.