The Rebalance of Value

Finally, it’s here. For a year or two now, several venture capitalists have said: “Winter is coming”. They had seen their share of overvalued companies, some in their own portfolio. I am starting to see reality hit some companies in the face. When they get low on cash they try to raise more and they realize that the appetite isn’t there.

There is a misconception that when a startup raises money at some valuation it’s the true value of the company. It isn’t. That price is really the ending point of a negotiation. It’s sort of a market driven price, but it’s not a classic market driven price like a public stock.  First, not every VC has a shot at every deal.  Raising money isn’t a transparent process like stock trading is.  It’s also a small group of people in a closed network deciding on a value.  That’s not a competitive market even though venture capital is competitive.

When VC’s value a company, they do look at numbers. It is not like an analyst going over a SEC 10-K and deriving the book versus market value. Certainly, you can crunch book versus market but rarely does it say anything meaningful about a VC-backed firm.

This story from this Wall Street Journal article is telling. It’s the story of Beepi. I had never heard of Beepi before this article, and I don’t mean to demean Beepi. There are plenty of other startups that can tell the same story.

Founded in 2013, Beepi caught on in San Francisco by giving people a fail-safe way to sell used cars online. Beepi guaranteed sellers a price, and if it couldn’t find a buyer in 30 days, it purchased the car. Beepi marked up the price and pocketed the difference.

Venture capital poured in, and its valuation surged from $12 million in early 2014 to $525 million by mid-2015. Beepi moved out of its cramped office by a Carl’s Jr. and into a glassy building where the chief executive zipped around on his own Segway. Staffers enjoyed quinoa salad and turkey meatball lunches and dinners when they often stayed late, and unwound with ping-pong or Nerf guns.

Most people will focus on what the staffers did. I see the move from $12M to $525M in 16 months and wonder how the hell it happened. That’s a 4275% gain in that time period.  An alternative universe if I ever saw one.

Profits are a big deal.  It’s what makes a business sustainable.  As my old friend Professor Paul Magelli said, “If you don’t make money it’s not a business it’s a hobby.”  In my own portfolio, I am loving the focus of CEO’s to get to break even.  That goes against Silicon Valley Venture Capital Theory 101.  Except, when the company is sustainable, it has better bargaining leverage with VCs.

As a VC, there is some ego and hubris derived from seeing appreciation like that.  It certainly makes a conversation with a limited partner, or a potential limited partner a lot easier.  The reality is rarely if ever are companies moonshots.  They get built over time.   Of course, that conversation gets tough the next time around when the company is out of business or does a massive down round.  It could be the new Series D will be an abbreviation for Series Down Round.

As a CEO, even if you can raise at a crazy valuation, should you?  The answer is it depends.  A good CEO doesn’t think about their next round.  They think three rounds into the future.  Of course, because it’s crystal ball stuff you aren’t going to be right but thinking about the future helps put some rigor and discipline into what you are doing today.  It helps the company stay within itself and be in that sweet spot of growth.  My friend John Geokaris loves to ask entrepreneurs the question, “How do your costs scale if what you are doing is wildly successful?”  Too much success can put a gigantic strain on working capital and resources.  It’s a first world problem.

If the company does a seed round at X, and can do an A round at some multiple of X, where should the next round be?  If you are growing at a rapid clip, that Series B round is where a lot of money will be made by the team and the initial investors.  For a number of reasons, seed rounds have jumped in valuation from the old $2M-$5M pre-money to $8M. That’s forced Series A up as well.  But, where should the B round be?  C round?  Can the business really be valued there?  If a big company or PE firm was going to buy the company, what would the valuation be?  Can the business sustain itself if you can’t get funding?

Entrepreneurs and investors need to be honest with themselves to figure out what is driving everything.  Very often, inexperienced investors flush with cash will get in and overvalue a deal.  Another problem is strategic investors come in and way overvalue a deal.  They make it impossible for next rounds to get done.

I have had more than one entrepreneur tell me, “We can’t have a down round.”  The alternative might be a less than lackluster acquisiton where the entrepreneur leaves a lot of money on the table. Or worse, going out of business.

 

  • awaldstein

    If you hold to the fact that if you don’t make money you are not a business is simply not always true.

    tumble. twitter. many others were bought and created value for the owners and investors and in actuality were not real businesses.

    hate to say this but in actuality they are not always connected.

    • They didn’t have net profits, but they had profits. Tumblr was a stinker post acquisition.

      • awaldstein

        My point is only that as a VC your job is to create wealth and that is not always the same as creating a business.

        Investors are fundamentally different then entrepreneurs at their very core.

        VCs build a portfolio and hedge their bets. Entrepreneurs lay it all out there.

        VCs bring logic to the table, talk model and metrics, entrepreneurs are at least in the early day simply finding voice to an idea and a skeleton to its possibilities.

        I find the connection between the entrepreneurial spirit and the portfolio of VC to be one of the oddist and interesting pairing history has given us. The oddest of couples in many ways.