Deal or No Deal

I have lately begun to watch NBC's 2nd best show (behind the Office), Deal or No Deal. Hosted by Howie Mandel, formerly of inflatable plastic rubber gloves, the show involves 24 models holding cases each with dollar amounts ranging from $.05 to $2,000,000. The contestant determines his or her prize by choosing which cases to 'take off the board'. The goal is to choose the cases with the lowest dollar amount and be left with one case containing the highest dollar amount. As cases come off the board, a 'Banker', who is shrouded in the shadows of an office above the game floor, intermittently offers the contestant a dollar amount to walk away from the game. Theoretically, that amount should equal some risk adjusted value for walking away from the chance to win the biggest amount left on the board.

'Deal or No Deal' is a good analogy for the VC world and lately it seems like all the cases coming off the board are small numbers and the 'Banker' is delivering valuations that are higher and higher. Often times the risk/reward equation makes sense, as there are some legitimate and good companies out there today with huge market opportunities. However, amidst all the large numbers, some less than impressive business are soliciting offers from VCs where the risk does not offer adequate reward. While some of these inflated valuations are being generated by companies playing in white hot sectors like online advertising and e-commerce, others are simply the result of bloated capital structures where previous VCs are looking to protect legacy investments. Neverthless, lots of these companies are getting funded.

While deal-hungry VCs are happy to find a place to store their capital for now, the long term effect on IRRs will not be pretty for undisciplined investors. In a few years, it may be the LPs that are saying 'no deal' when the vintage '04, '05 and '06 funds go out to raise capital with less than impressive results.