Y Combinator’s Paul Graham warns of tightening wallets in wake of Facebook IPO

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Facebook has been one of the most prominent tech IPOs to date, and its failure to perform at the level of the public’s expectations is sending shockwaves throughout the tech community. In response to the underperforming IPO, Paul Graham, the venture capitalist and co-founder of seed funding capital fund Y Combinator, emailed an ominous message to its portfolio of companies about the hard times ahead for early stage startups that are seeking out investors.

“Jessica and I had dinner recently with a prominent investor. He seemed sure the bad performance of the Facebook IPO will hurt the funding market for earlier stage start-ups. But no one knows yet how much. Possibly only a little. Possibly a lot, if it becomes a vicious circle,” Graham writes.

Much of this does in fact directly result from Facebook’s stock price, which opened today at $26.70 per share, dropping more than $11 dollars since its IPO at $38. At a $26.70 opening, Facebook’s market cap (valuation) sits at $58.77 billion dollars, far below the valuation that the company had opened at $104 billion.

Some may not be surprised by Facebook’s performance. It has been a vertically structured company, relying solely on advertising revenue with an aggressively priced IPO. Google on the other hand expanded its search advertising business with its foray into various facets of technology and endeavors including its suite of productivity products and even a self-driving Google car. At this rate, Facebook’s future may rely on its rumored development of a Facebook smartphone, or else risk disappearing in a matter of eight years.

But why would Facebook’s performance affect other start-ups?

Valuations among start-ups seeking funding will typically be pegged to an existing IPO as an indicator of how the start-up may ideally perform in the market. For social-networking applications and its variants, the valuations may be pegged to Facebook’s own, which has toppled nearly 50 percent. That could mean that Facebook-like companies will be worth considerably less than initially anticipated. Consequently, investors will expect lower valuations from start-ups and invest less than they would have otherwise. This is the same sentiment that Graham expressed in his letter, followed by the suggestion that companies should think about their bottom line and revenue.

“What does this mean for you? If it means new start-ups raise their first money on worse terms than they would have a few months ago, that’s not the end of the world, because by historical standards valuations had been high. Airbnb and Dropbox prove you can raise money at a fraction of recent valuations and do just fine. What I do worry about is (a) it may be harder to raise money at all, regardless of price and (b) that companies that previously raised money at high valuations will now face ‘down rounds,’ which can be damaging.”

Facebook’s fallout may bring start-up founder’s expectations, particularly those pitching social-networking apps, back down to reality. After all, as an investor, who would want to pump money into another Color? The start-up raised a whopping $41 million from investors even before its launch, but disappointed with a meager 30,000 daily users.

Paul Graham may be right when it comes to how Facebook’s IPO will impact the investor’s sentiments among start-ups, but the tech world shouldn’t lose focus of what actually causes the tech bubble to pop. The true dangers lie for the economy will be at the hands of the companies on the verge of an IPO. The bubble pops when the vicious cycle where in companies will seek higher valuations to make its IPO underwriters and initial investors “rich,” according to a source at Citi Bank, despite the risk that an inflated valuation may send stock prices tumbling.