An Open Letter to Mark Suster — Something Doesn’t Add Up With Startup Valuations

Dear Mark Suster,

We’ve never met, but I have a lot of respect for you. I read your posts regularly, and I admire Upfront Ventures.

But…

I was disappointed with your recent post called “What Most People Don’t Understand About How Startup Companies are Valued”.

I run a small boutique consulting firm in Tel Aviv called Value Your Startup, where we help investors and startups ground the numbers behind their financial decisions in reality — based on intrinsic value and fundamental analysis of the startup’s unique strategies — which we then use to project cash flows to stakeholders. We climb a steep mountain because our methodology is based on revenue, expenses, profit, dynamic systemic and non-systemic risk, and free cash flow, all of which contradict much of the group-think behind valuations.

I read your post with high expectations, wondering if you would justify our methodology. I was hoping that you would say something about how valuations are falling because the investing community is finally moving away from market comparables and growth multiples and towards a focus on cash flow and profitability. But the crux of your post — “Why Valuations in Recent Years were Irrational” — seemed misleading in answering the question of why the price of technology companies is falling.

You begin with referencing the enormous wealth creation for former tech employees, who went on to become tech investors. According to Facebook’s 10Q from Sept 2012, mere months after their IPO, the company had 4331 employees. Yes, many of them made a pretty penny from the IPO, and some of them even went on to become investors, but it seems highly doubtful that this handful of former employees can drive up valuations in the United States; and definitely not across the globe. Same goes for all the former employees from Apple, Google, Twitter or wherever.

The Center for Venture Research at UNH makes this point as well. Compiling their research reports reveals an interesting trend:

While the total number of investments made, and the estimated amount per angel investors, has steadily increased in the last 15 years, there is no “spike” in the numbers to indicate a huge influx of noob investors, as you posit. In fact, the average investment size, and the average amount invested per person, decreased over time and have remained fairly flat over the last four years, which coincides with the recent big increases in valuation

Therefore, shifting the blame to noob investors with newly disposable income seems hasty.

Next, you mention institutional players, namely mutual funds, who have been eager to get in on the action. Over the past four years these players have been lured by potential returns and pushed by negligible interest rates as set by the Fed. CB Insights, our only friend when it comes to semi-credible data, estimates that mutual funds invested $8.5B in tech in 2015, up from $2B in 2012. Yes, this is a huge amount, but it is a drop in the bucket when you consider the fact that BlackRock alone boasts of over $4.5 trillion in assets under management.

But is this the reason why valuations are irrationally high? Probably not. A case can be made, as you do, that this influx of cash from institutional “me too” players has adversely affected valuations in the private market, but it is not the core reason.

Over this same period, VC investments reached an all-time high of $74.2B in the US.

Taken together, an interesting narrative emerges:

These graphs point out that clearly the lion’s share of investment activity over the recent years is from VCs themselves. More than that, VCs are pushing out Angel investors, and institutional players still represent a tiny amount of the total pool (8%).

The average VC investment in 2012 was roughly $7M. In 2015 it was $15.2M. If we make a gross assumption that the average equity stake of each investment is the same over time, it means that valuations DOUBLED in four years for VC backed companies.

In other words, it seems like the real culprit behind irrational valuations is the VCs themselves, who drove up valuations internally, without influence from institutional players or noob investors. Could it be that the valuation methodology of using multiples and comparables based on market sentiment has diverged from the fundamentals of cash flow and earnings?

To many “outsiders”, it seems like the standard VC approach of applying market comparables to find the value of a startup depends entirely on what someone else paid for a somewhat similar startup. But that other startup was valued based on yet another startup. When this methodology is applied on an industry wide scale, market sentiment becomes a disproportionately large ingredient in valuation, as opposed to the actual earnings and subsequent returns to shareholders.

As Sramana Mitra, founder of 1M/1M, recently stated on Quora: “Valuations have no rhyme or reason, and no anchoring in fundamentals. Investors are showering capital on a few companies like Flipkart, Ola, and Snapdeal at a scale that makes no sense.”

And here is the point: If this is the case, and you and your VC counterparts have been talking about this behind closed doors for two years, why was nothing done to correct this behavior?

But who am I to ask you any of this? I’m just out here in the boonies of the desert, on the ass-end of the Fertile Crescent, trying to work with investors like you to make financial decisions based on the core business potential of the company, and not on what I read on TechCrunch. Maybe it would be more impactful to hear Gary Cohn, President and COO of Goldman, say that “Earnings and cash flow matter”.

Hoping to hear from you…