Tech valuation 🚀 🌒

Anecdotes and data

Startup valuations 🚀 🌒

Yet even for investors, the pace is stupefying. The recent media favorite is Clubhouse, the audio-only social app. It was valued at $1 billion even though it did not make any money, yet. But among venture investors, Retool, a low-code software platform, is generating more fuss. Consumer social apps are first measured by users as they scale to reach a critical mass of userbase that can then be monetized. But business software tools are measured by revenue from the start. Retool was valued at $1 billion with only $10M of revenue. A 100x revenue multiple, when not too long ago 10x was the norm. These exemplify how startup valuations have soared over the past decade.

It is an interesting dynamic because investors don’t like high prices, yet they continue to drive it higher. Not only will returns be lower, but it will also be more difficult to process an investment. In venture, there is a lot of selling needed to get to the point of owning company shares. There is no one-click investing like in public markets. First, investors need to sell to founders that they are the best partners. Then to their partnership that there is a lot of money to be made.

A higher valuation also means more risk. As valuations increase, so do the funding rounds, which means investing a larger portion of the fund. Investing 1% of the fund is fundamentally different from 10%. From a portfolio management view, 10% concentrates the fund too much. From a deal perspective, convincing investment partners that risk is worth it is another hurdle.

Going back to Retool, Sequoia led the $20 million series A round. According to Pitchbook, the average venture fund raised in 2020 is $235 million. The round would have been 9% of the average fund. Incorporating the practice of reserving an equal amount for future rounds, the commitment is effectively 18%. But for Sequoia, $20M is just 0.9% of the $2.15 billion it raised in 2020 for US investments.

So, in this essay, we explore why investors continue to bid up startups. Even when over 90% of them think startups are overvalued.

Supply and demand

Statistics reveal just the surface of the matter. The set of startups that a venture fund can invest in is much smaller than what the charts suggest. There are easily 10–20 companies building competing products, and investors can only choose one. Investors have an informal agreement with founders to not invest in competitors. Contrast this to the public stock investors who can invest in every company in a sector. Coca-Cola’s CEO does not care if you own both Coke and Pepsi shares.

Hence, you’ll often hear that venture investors are frantically chasing the best deals. What this often means is the best leadership team. Convince enough engineers to join, you can build any product. There is only one Jack Dorsey. One Elon Musk. One Bill Gates. One Jeff Bezos. One GP told me recently that while there are several exciting startups he could invest in this year, he is dropping everything to focus on investing in a stealth startup run by an enterprise software legend. He is convincing the CEO to take his money even though Sequoia and a16z have already verbally committed to writing blank cheques.

How venture capitalists value startups

My venture 101 professor taught several startup valuation methods, each with its nuances. But all boil down to the expected exit value. In a survey of 885 venture investors, 86% answered that expected exit is a key consideration. Half said it is the most important. So how are startup exit values calculated? On the crude end, investors look at comparable public companies. Snowflake will replace Oracle with a much better product. Therefore, Snowflake will eventually be worth over $200 billion. On the sophisticated front, investors estimate the likelihood of different exit scenarios and calculate a probability-weighted return. I’ve illustrated a simple example below, but you can find excellent examples from Bessemer’s investment memos and Ulu ventures’ decision making framework.

A few factors essentially determine the valuation equation. So let’s look dive into what data says and answer the questions:

  • Did the exit rate increase? Exit rate is the probability of getting acquired or going public.
  • Did exit size increase?
  • Did cash-on-cash (CoC) return increase? CoC is the exit size relative to startup valuation.

Did the exit rate increase? No, it decreased by 5% points.

Did exit size increase? Yes, across the board.

Did CoC return increase? Yes, largely because of IPOs.

Using the probability framework earlier, we can see why investors continue to pile money into venture capital. Despite valuations going to the moon, expected returns have increased.

Public market valuation 🚀 🌒

But do those valuations make sense?

In 2020, only 20% of tech companies that go public were profitable, almost as low as in the dot-com bubble. Goldman Sachs created an index of unprofitable tech companies, which tripled in value from last year. It seems like the more money a tech company losses, the higher the price investors are willing to pay.

The rationalization peddled around is that software companies are now growing much faster than before. Sure, they might be losing cash, but it is for the sake of growth. That justifies the higher valuation multiples across the board. Supposedly.

Going back to fundamentals, a company’s financial value is determined by three things: cash flows, growth, and risk. So let’s dive into the data and answer whether companies in the EMCLOUD index:

  • Are growing faster?
  • Are burning more cash? This is calculated with free cash flow margins.
  • Are less riskier?

Instead of looking at the index average, we’ll look at cohorts based on when companies went public. It reveals how companies have and haven’t changed.

Growing faster? No, it is the same.

Burning more cash? Yes, by a lot.

Less riskier? Yes. Rather, software ate the world.

You are probably inundated with data at this point, so I’ll spare you from charts about the rise of smartphones, broad access to the internet, and the shift to the cloud. Simply put, we became a software-first world. The question is not why software but why not. In 2012, I bought a 50mm f1.8 camera lens to get the bokeh effect I love in portrait photos. Today, I get the same effect with one click in my phone app. There is an app for (almost) anything a consumer wants. I imagine that when Marc Andreessen was writing his seminal essay a decade ago, the question that investors thought then, “Will this even work?” Today it is, “This makes total sense. Why hasn’t anyone built this yet?” Software is not a risk anymore. It ate the world.

But there is a difference between being bullish about software as an industry and a software company. Investors, both retail and institutional, are applying the same excitement to all companies, especially unprofitable ones. Am I sounding the bubble alarm? Maybe. But what I am sure of is that today’s public software companies are not growing any faster than before and are burning a lot more money.

What should I do as a venture investor? Valuations will remain elevated with more venture capital chasing fewer startups. Venture returns as an asset class might compress. That means I just have to be much (much) better at finding, picking, winning, and helping startups than others.

I bet that if I asked Marc the same question, he’d just send me the screenshot below.

Actually, he will just ignore me.

Originally published on Substack.

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Writing about and investing in AI companies

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