Exceptions Not the Rules
Early Stage Valuations: All rules can be broken but only for a very good reason
Welcome to issue #5 of Indiscrete Musings
I write about the world of Cloud Computing and Venture Capital and will most likely fall off the path from time to time. You can expect a bi-weekly to monthly update on specific sectors with Cloud Computing or uncuffed thoughts on the somewhat opaque world that is Venture Capital. I’ll be mostly wrong and sometimes right. Views my own.
Please feel free to subscribe, forward, and share. For more random musings, follow @MrRazzi17
Personal update: I recently joined Ridge Ventures as a Principal, focusing on enterprise software in the early stages (seed/series A). If you're an enterprise founder, I'd love to chat! I'll be moving back to the Bay Area in the New Year; drop me a note if you want to grab a coffee or a Hawk Hill ride!
Now, on to the update. In my prior posts, I deciphered markets or existing trends such as Cybersecurity and Zero Trust, consumer applications propelling a once-stagnant CDN Market, and the evergrowing API economy and security vulnerabilities. In this post, I tackle an important yet overlooked VC conundrum: "to pay up or not to pay up?"
As an investor who's relatively young in my career—and having worked during a bull run—I struggle with knowing "when to pay up" to partner with a company. That is, knowing when to invest capital below a certain ownership threshold and, usually, a hefty valuation attached. Hindsight is always linear, but having the foresight to predict the future and the investment is almost impossible, especially at the earliest stages of company formation when it's usually a founder(s), an idea, maybe an espresso machine, and essentially an unproven market.
We've been in a bull run for the past two decades, which once transformed a small industry in Silicon Valley into a vast machine serving as the backbone of the most innovative companies globally. Venture capital has spread into new markets, geographies, and talent pools, and, as a result, some thought the good times would keep rolling. To that end, we've endured a global pandemic, the Ukrainian and Russian wars, China's purging of the tech industry, and rising interest rates which affected public and private markets last year. Technology companies were rewarded with valuation multiples that far exceeded historical norms for various reasons. Their views on their respective growth rates and capital raises were incredibly rosy. The market rewarded future expectations instead of intrinsic value based on fundamentals such as Free Cash Flow (FCF), quality revenue, and relative burn.
2021 summarized in one tweet:
2022 summarized (kind of) in one tweet:
As I write this, I believe that going into the new year, we will continue to experience loose monetary policy, inflation, and interest rate hikes, affecting public tech multiples and capital accessibility. Start-ups will have to emphasize prudence and substance over irrational and unguided growth. Yet, despite the falling expectations for early-stage valuations, some large rounds (w/large valuations) are still being done on the early-stage front (>Series A) with unjustifiable valuations, that is, in any quantifiable way. Put pre-product, pre-revenue, and whatever else has a "pre" in front of it. Why is this?
To answer these questions, I turned to the history of the venture, particularly during the dot-com bubble, which is comparable to what we're currently living through in venture and tech (according to those who lived it) today. I'm reminded of the Kleiner Perkins investment into Google, which the ever-charismatic John Doerr led. In a later recall, the first interaction between John Doerr and Larry and Serge went something like this:
“Doerr asked, “How big do you think this could be?” “Ten billion,” Page answered. “You mean a market cap, right?” “No, I don’t mean market cap. I mean revenue,” Page declared confidently. He pulled out a laptop and demonstrated how faster and more relevant Google’s search results were compared with its rivals. Doerr was flabbergasted and delighted. Revenue of $10 billion implied a market capitalization of at least $100 billion. This was fully one hundred times more than Doerr’s estimate of Google’s potential; it implied a company as big as Microsoft and much bigger than Amazon. Whether or not this goal was plausible, it certainly telegraphed audacity. Doerr seldom met entrepreneurs who dreamed bigger than he did.” – The Power Law
John led the investment on June 7th, 1999, for $12M for ~10% of Google. Later, he recalled, "I have never paid more money for so little a stake in a startup.” Citing the Google example may be irrational as it defied the odds and is the power law 10x over. The reality with large runaway valuations is this: with astronomical valuations come astronomical expectations. Some might counter by saying that you can never have enough cash or "cash is king.” I believe that this warped view that can often lead to stagnation and entropy for start-ups. Expectations continue to grow, and pressure from employees and investors starts to mound. Over-funding can often create an illusion in the market that a start-up is a "sure thing." From what I've observed of founders, being a start-up founder is already stressful (note: I have not started anything in my life). Adding additional market pressure for no apparent reason is another distraction pushing companies away from being "default alive." I'll save the remainder of this topic for another post. So despite the market exuberance and ensuing corrections, why do some early-stage start-ups get highly valued despite nominal proof points that quantify their worth?
I’ve listed several variables below that often share similar characteristics of highly valued companies at the earliest stages; it’s not perfect, but it can tie a thread between Google several decades ago to the companies of today and tomorrow whose valuations are above the mean.
Demand for companies of similar scope, quality, scale, market, and thesis
Founder(s) background (e.g., two-time founder, led and grew teams at blue chip companies)
Competition among other investors who are eager to invest (e.g., FOMO)
Most important, and always hard to calculate, is the investors’ willingness to pay
Founders create the rules.
For Seed and Series A based companies, there is never a straightforward rule of thumb or clever math formula that tells you the company's value. Instead–as the Google example illuminates–the founder(s) have more control over defining the worth of their start-ups, and the best founders know the value of their start-ups intrinsically, whether it be the future or present value. And once the founder has figured out the value of their start-up, the best ones often can persuade or even educate investors on their vision resulting in their ability to have VCs give them capital and a commensurate yet subjective valuation that can be seen as either astronomical or bargain. The founder(s) ability to convince VCs of the value of their start-up can often work hand-in-hand with a VC who may want to inflate valuations which play well into VC mimetic desire (e.g., nothing sounds better than being the genius that invested in the following Google). Success begets success, and reputation begets reputation.
And so, to answer the original question of why–despite the market correction on valuations in 2022–some start-ups are still being overtly valued with little to show? It's a mix of a founder's undogged ability to understand the potential value of their start-up concretely, educate the market, and convince VCs of their vision. As for the VC, the best ones who generate outsized returns usually find asymmetry in the market, founder, and product and can justify the margin of safety if it doesn't work out. "Paying up" is not an act of blind faith, however. As with any investment decision, context is king.
Mallaby, S. (2022). The Power Law: Venture Capital and the making of the new future. Penguin Press.